Business Economics

Dr. Shreya Biswas

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Unit 1

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Unit 1
• Introduction to Business
Economics
• It’s Scope
• Why Economics is Needed
• Basic Process of Decision
Making
• Homoecomomics
• Bounded Rationality
• Theory of Firm
• Their Objectives
• Reason for their Existence
• Types of Firm
• Resources Employed by the Firm
• Challenges Faced by the Firm
• Constraints Faced by the Firm
• Different Types of Firms under
Existence
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 So What is Economics?

Resources are scarce

Economics is the study of how individuals and society choose to

use scarce resources that has been provided to us by nature and
society.
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So is it Behavioral or Social Science?

It is a study of how people make choices. These

choices that people make, when add up
translate into societal choices.

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 Why Study Economics?

Reasons to study economics:

• To learn a way of thinking
• To understand society
• To be an informed citizen

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 Objective 1: To Learn a Way of Thinking

Opportunity
Cost

Three Fundamental
Concepts of Economics Marginalism

Working of
Efficient 7

Markets
 Opportunity Cost

The best alternative that we forgo, or give up, when we make a choice
or decision is called opportunity cost.

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 Marginalism

Marginalism is the costs and benefits that arise from a decision. It is the
incremental cost and revenue that arise from the decision.

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Marginalism

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 Marginalism Example 1

Suppose you are travelling from Ahmedabad to Mumbai on an

official visit. Your mother stays in Pune and you decide to visit
her. The cost of the visit will be only from Mumbai to Pune and
not Ahmedabad to Pune, since you were any ways travelling to
Mumbai.

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 Marginalism Example 2

For an airplane that is about to fly with empty seat the marginal cost
of an extra passenger is zero as the total cost of the trip is roughly
unchanged by the addition of an extra passenger. Therefore selling a
few seats at student’s discount can be profitable even if the fare of
the seats is below the average cost per seat of making the trip as
long as the airline succeeds in filling the seats that otherwise would
have been empty.
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 Efficient Markets – No Free Lunch

Markets where any profit opportunities are eliminated almost

instantaneously, are said to be efficient markets.

Any profit opportunities existing in the

market are quickly wiped out.
Example – Indian telecom sector

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 Objective 2: To Learn a Way of Thinking

Why do we study economics?

To understand society in a better way. Past

and present economic decisions have a lot
of impact on the character and life of the
society.

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Society Changes are Often Driven by Economics

Example 1: Changes in communication with

the advent of World Wide Web (www.)
Example 2: Changes in data usage with the
advent of Reliance Jio.

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Objective 3: To be an Informed Citizen

Why do we need to be informed?

• To understand the world situation like
the impact of recession
• The logic behind local and national
policies like implementation of GST,
farm loan waiver, incentives given in
post Covid led lockdown. 16
Scope of Economics

• Inflation
• Unemployment
• Fiscal Deficit
• Budget Line
• Rational Consumer

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 Major Division of Economics Individual
Decision Making
Microeconomics Units Like Firms
and Households

Economics

This deals with

Macroeconomics economy as a
whole

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 Method of Economics

Positive Economics
Questions
Asked in
Economics
Normative Economics

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 Positive Economics Vs Normative Economics

Positive economics tries to Normative economics looks at the

understand the behavior and
operation of economic systems
without making judgements
about whether the outcomes
are good or bad.
outcome of economic behavior
and evaluates whether they are
good or bad. This included
judgements and prescriptions for
courses of action. They are also
called policy economics.

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 Model, Variable and Ockham’s Razor

Model- It is a formal statement of a theory. It is usually a mathematical

statement of a presumed relationship between two or more variables.
Example: Law of demand – When price increases for normal good the demand
falls and vice versa.
Mathematical Model – y = a - bx
y = quantity demanded
x = price

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 Model, Variable and Ockham’s Razor

Variable - It is a measure that can change from time to time or from observation
to observation.
Example: Law of demand – When price increases for normal good the demand
falls and vice versa. Here there are two variables; price and the quantity
demanded
Mathematical Model – y = a - bx
y (quantity demanded) and x (price) are variable

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 Model, Variable and Ockham’s Razor
Ockham Razor – The principle in which irrelevant detail is cut away is called
Ockham Razor. Economic models are abstractions and often the details are
stripped away to expose only those aspects of a behavior that are important to
the questions asked.
Example: Law of demand – When price increases for normal good the demand
falls and vice versa. In the short run the demand for a commodity is impacted
maximum by price.
Mathematical Model – y = a – bx
In the short run the demand model consists of price only. 23

https://www.youtube.com/watch?v=ld0-20z_7PA
 Ceteris Paribus – All Else Equal

Ceteris Paribus – To isolate the impact of one single factor

Example: Law of demand – To isolate the impact of price on quantity demanded
we assume that all other factors are kept constant

Mathematical Model – y = a – bx
Here to study the impact of price on the quantity demanded we have assumed
other variables like income of consumer, price of complementary and substitute
goods etc. are kept constant.

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 Price of the
Commodity
(P)

Price of the
Income of the Demand for a Complementary
Consumer (Y) Commodity (Q) Commodity
(Pc)

Price of the
Substitute Q = f(Y, P, Pc, Ps)
Commodity 25

(Ps)
 Testing Theories Models and Empirical Economics

When a theory fails to explain what is observed or when another theory better
explains what is observed then the theory is rejected. Theories are tested
through data analysis. The collection and use of data is called empirical
economics.

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 Criteria to Judge Economic Outcomes

1. Efficiency
2. Equity
3. Growth
4. Stability

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 Efficiency

Efficiency – This means allocative efficiency. An efficient economy is one that

produces what people want at least possible cost. If the system allocates resources

to the production of goods and services that no one wants, then it is inefficient.

Failed

Resources allocated for the production of goods and services that no one
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wanted.
 Equity

Equity – Equity means fairness and it lies in the eye of the beholder. To some
fairness is more equitable distribution of income and wealth, while for others it is

giving people what they earn.

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 Equity Vs. Equality

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Hence subsidies are given to the underprivileged

 Growth
Economic Growth – It is increase in total output of the economy. If the output
grows faster than the population, then the output per person rises and the
standards of living increase.
Research and development are often subsidized by the government as they
contribute to the long term growth. Similarly investing on infrastructure like
ports, roads, airports, electricity contributes to economic growth.
If domestic wealthy people invest outside country then the growth of the
domestic country slows down.
If external wealthy people invest in the country under consideration then the
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growth of that country increases.

 Growth

Foreign Direct Investment Economic Growth

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 Price of the
Commodity
(P)

Price of the
Income of the Demand for a Complementary
Consumer (Y) Commodity (Q) Commodity
(Pc)

Price of the
Substitute Q = f(Y, P, Pc, Ps)
Commodity 33

(Ps)
 Basic Process of Decision Making

Continue to Improve
Implement and Test the Decision
Select the Best Possible Solution
Identify Possible Solutions
Analyze Data
Gather Data
Determine the Objective 34

Define the Problem

 Homoeconomics – The Concept of Economic Being

The economic being is a representative consumer that

has certain characteristic that are universal and core
of each consumer throughout the World

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 Non - Satiation

Possession of Clarity of
Information Preference
Basic Characteristic of
Representative Customer

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Selfish Motive
Non-Satiation – A consumer would prefer more of a good over
less and less quantity of bad over more

Clarity of Preference – Also known as transitivity of

preference. If good A is preferred to good B and good B
preferred to Good C then good A must be preferred to good C

Selfish Motive – People work in self interest rather than with a

wish to harm themselves

Possession of Information – Individual consumers make

informed decision 37
Bounded Rationality

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 Non -Satiation

Possession of Clarity of
Information Rationality Preference

Selfish Motive

But are Human Beings Always Rational?

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Non-Satiation – Acceptance of a good to a point where it
fetches some non – negative satisfaction

Clarity of Preference – People have clarity of preference for a

given time and transaction, but there preferences may change
over time

Selfish Motive – People work for charity and donate their hard
earned money

Possession of Information – Consumers draw a boundary in

information seeking in accordance to his/her personal
interest, cost of seeking information and the benefit derived 40

from the information sought.

 Example of Bounded Rationality

Buyers of Infosys Stock Sellers of Infosys Stock

Does this Mean some People are Irrational?

People have Different Objectives and Understanding 41

It is the Bounded Rationality that Makes the World Move

Otherwise we would have only buyers or

sellers

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 Homoeconomics Vs. Bounded Rationality

As we have bounded rationality that differs from each other therefore the
market functions as buyers and sellers can co-exist. 43
Theory of the Firm

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What is a Firm and why do they Exist?

A firm is an organization that combines and organizes

resources for the purpose of producing goods and/or
services for sale.

It exists to save on transaction cost.

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 How Firms Save on Transaction Cost?

By internalizing many transactions i.e. by performing

many functions within the firm, the firm saves on
transfer pricing, taxation on multiple transactions, and
reduces volatility on business by reducing dependence
on outside agencies.

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 Goods and Services

Consumer Expenditure

Households Firms

Wages, Rents, Dividends

Factors for Production

Circular Flow of Income 48

 (Rs.) (Rs.)
Product
Goods and Services Goods and Services
Markets

Circular Flow of
Households Economic Activity Firms

Economic Economic
Resources Resources

Income (Rs.) Factor

Factor Payments (Rs.)
Markets

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 Proprietorship Firm Fir
m
sO
wn
e db
yI
nd
ivi
du
als

Firms Owned by Two or More Individuals

Partnership Firm Types of Firm
e rs
h old
c k
St o
d by
wne
s O
m
Fir
Corporations
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 Objective of the Firm

Short Term Profit Long Term Gain

Both are Important

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 Objective of the Firm

How do we know both short term gains and long term profits
are important for firms?

Firms work for arranging working capital and also spend

money on capital equipment

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 Objective and Value of the Firm

Maximize wealth and value of the firm

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 So How do We Calculate the Value of the Firm?

For this we have to calculate the present value of all future profits
of the firm

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 Land

Resources
Employed by Capital
Labor
the Firm

Entrepreneur 57
 Land

User
o r Land P ay s t
d f o t he
Is Use Own
e r
Is Used for
Land Factory Building Rent
Is U
s ed
For

Office Structure

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 Labor

Labor All workers from Wages

watchman to CEO

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 Capital

Financial Capital

Machinery

Equipment
Capital Interest
Furniture

Fixtures

Technology
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 Entrepreneur

Most Critical Factor

Land

Entrepreneur Labor Productive Functioning

Capital

Profit

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 Constraints on the Operation of the Firm

Constraints on the operations of the firms can be categorized in

two broad categories:
• Resource Constraint
• Legal Constraint

Firms Face Constraint Optimisation

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 Resource Constraints on the Operation of the Firm

Lack of Raw Lack of Skilled

Materials Workers

Restrictive
Lack of Factory Resource Constraints on Government
Capacity the Operation of the Firm Polices

Lack of
Warehouse Lack of Capital
Space 63
 Resource Constraints on the Operation of the Firm

Health
Labor Laws
Standards

Safety
Bankruptcy Legal Constraints on the Standards
Laws Operation of the Firm

Monopoly Act Environment

Laws 64
Can a Firm Grow Indefinitely?

Why?

Diseconomies of Scale

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 Why Large Firms are
Difficult to Manage

Causes Increased
Communication Traffic Causing Diseconomies
of Scale

Resulting in Ineffective
Distancing of the Top Control
Management from the
Operation of Each Division
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 Limitations on the Theory of the Firm

Wealth or Value Maximization is Considered as Narrow

Broader Definition

Sales Maximisation Model William Baumol

Principal Agent Model Oliver Williamson

Satisficing Behavior Richard Cyert and James March

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 Sales Maximisation Model

Managers of modern corporations seek to maximize sales after

an adequate rate of profit has been earned to satisfy the

stakeholders.

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 Principal Agent Problem

Managers more interested in maximizing their utility in terms

of compensation (salaries, fringe benefits, stock options, etc.)
the size of the staff, the extent of control over the corporation,
lavish offices and so on than in maximizing corporate’s profit.
The agent (manager) more interested in maximizing his/her
benefits than maximizing principal’s (owner’s) interest

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 Satisficing Behavior

Managers of large corporations are not able to maximize

profits because of uncertainty and lack of adequate data. They
are only able to strive for some satisfactory goal in terms of
sales, profits, growth, market share etc. This is called satisficing
behavior.

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Profit

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 The Nature and Function of Profit

• Business Profit versus Economic Profit

• Theories of Profit

• Function of Profit

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 Business Profit Versus Economic Profit

Business Profit = Revenue of the firm – Accounting Cost

(Explicit Cost) of the firm

Economic Profit = Revenue of the firm – Explicit Cost of the firm –

Implicit Cost of the Firm

Economic Profit are also called as above normal profit

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 Explicit Cost = Accounting Cost

Wages of
Labors

Rent on Land Interest on

and Buildings Accounting Cost Borrowed Capital

Expenditure These are the cost

on Raw that appear on the
Materials balance sheet. 74
 Implicit Cost = Value of the Inputs Owned and Used by the Firms in
its Own Production Process

Wages of Family
Members Involved in Wages of the
the Business Entrepreneur

Rent on Self Interest on Self

Implicit Cost Owned Capital
Owned Land

Expenditure on These are the cost

Raw Materials that that do not appear
are Self Owned on the balance sheet.
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 How are the Concepts of Business Profit and
Economic Profit Important?

• Business Profit used for accounting and tax purposes

• Economic Profits are used to reach correct investment decision

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 Theories of Profit

• Risk Bearing Theories of Profit

• Frictional Theory of Profit

• Monopoly Theory of Profit

• Innovation Theory of Profit

• Managerial Efficiency Theory of Profit

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 Risk Bearing Theory of Profit
Above normal returns (i.e. economic profits) are required by
firms to enter and remain in such fields.
Example: 1. Petroleum exploration with above average risk.
2. Return on stocks has to be higher than on fixed deposits
because the risk is higher.

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 Frictional Theory of Profit

Profits arise as a result of friction or disturbances in the long

run.

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 Monopoly Theory of Profit

Firms with monopoly power can restrict output and charge

higher prices than under perfect competition and thus earn
profit.

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 Owing and Controlling the
Entire Supply of Raw
Materials

Economies
Ownership Monopoly of Large
of Patents Power Scale
Production

Government
Restrictions 81
 Innovation Theory of Profit

Profit is the Reward for the Introduction of a Successful

Innovation

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 Managerial Efficiency Theory of Profit

Firms that are more efficient than the average would earn
above normal returns and (economic) profits.

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CEO Microsoft
CEO Google
 Function of Profit

High Consumer want more Incentive for firms to

Profit of the output expand output

More firms enter the

industry in the long run
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Examples of Economic Profit and Business
Profit

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 Question 1
A recent engineering graduate turns down a job offer of Rs. 300000
per year and starts his own business. He will invest Rs.500000 of his
own money, which has been in a bank account earning 7% interest
per year. He also plans to use a building he owns in Bangalore as a
warehouse. That building has been rented for Rs. 15000 per month.
Revenue in the new business during the first year was Rs.1070000
while the other expenses were:
Advertising Rs. 50000
Rent of the showroom Rs.100000
Taxes Rs. 50000
Employees salaries Rs. 400000
Utilities Rs.30000
Supplies Rs.50000 86
 Question 1
Q1. Prepare an income statement showing business profit.
Q2. Prepare an income statement showing economic profit.
Q3. What do you think the engineering student’s decision be
regarding pursuing with his business?

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 Question 2

Kishore, a college intern, generally spends his summers working on

the College Maintenance Crew at a wage of Rs.60 per hour for a 40
– hour week. Overtime work is always available at an hourly rate of
1.5 times the regular wage rate. For the coming summer, he has
been offered the pizza stand concession at the Student Union
Building, which would have to be open 10 hours per day, 6 days a
week. He estimates that he can sell 100 pizzas a week at Rs. 90
each. The production cost of each pizza is Rs.20 and the rent on
the stand is Rs.1500 per week. Should Kishore take the pizza
concession? Explain.
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 Question 3
Rahul has just completed his MBA and is considering investing Rs. 20 lakh in a
retail store that he will be managing. The projected income statement prepared
by the accountant is as below:
Sales Rs.900000
Cost of Goods sold Rs.400000
Advertising cost Rs.100000
Depreciation Rs. 100000
Utilities Rs.30000
Miscellaneous expenses Rs.50000
However if Rahul had invested Rs.20 lakh in the bank he would have got an
interest of 5%. Also, if Rahul would have been working in another firm, he would
have earned Rs. 6lakh per annum.
Q1. Prepare an income statement showing business profit.
Q2. Prepare an income statement showing economic profit.
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Q3. Do you think Rahul is right in pursuing his business? Provide justification for
your answer.
 Question 4

Hema is a full time homemaker and also takes tuitions and knits
sweaters in spare time. While in Dubai in the summer holidays, she
bought some dress material for which she paid Rs. 50 per meter.
This material could be sold back to the local fabric shop in Cochin
at the rate of Rs.150 per meter. Hema is considering using that
material to make dresses, which she would sell to her friends and
neighbors. She estimates that each dress would require four
meters of material and four hours of her time, which she values at
Rs.100 per hour. If the dresses could be sold for Rs.900 each,
should Hema still make and sell the dresses.
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 Question 5

A manufacturer of personal computers has an inventory of 10000

backup storage drive that sold for Rs.1000 per unit last year. The
current market price of these drives is now Rs.700 per unit. By
adding one of these drives to their stock of personal computers,
the price of each computer is increased by Rs.800 per unit. Should
the drives be added to the personal computers? Explain with
justification.

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 Question 6

Swastika Electronics Ltd. has an inventory of 5000 unique

electronic chips originally purchased at Rs. 25 each; their market
value is now Rs. 50 each. The production department has proposed
to use these by putting each one together with Rs.60 worth of
labor and other materials to produce a wrist watch that would be
sold for Rs.150. Should the proposal be implemented? Explain

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 Question 7

Ms. Aastha Dave is a law graduate, working in a law firm. She is

earning Rs. 40000/month. She wishes to start her own firm, where
she expects to earn Rs. 1500000/annum. However, for that she
needs a office , the rent for which is Rs. 20000/month and she also
needs to hire a clerk, whim she has to pay Rs. 25000/month.
Should she start her own firm?

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Thank You

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