BUSINESS ECONOMICS

MBA FIRST SEMESTER NOTES

SUBMITTED BY: MASAKO EVODIA LEKHANYA

MODULE 1
MANAGERIAL ECONOMICS

MEANING

Managerial economics means employment of economic theory and quantitative methods to the
managerial decision-making process. According to Dr. Alfred Marshall, economics is a study
of man’s actions in the ordinary business of life which enquires how he gets his income and
how he uses it. Prof. Lionel Robbins defines Economics as the science, which studies human
behavior as a relationship between ends and scarce measures which have alternative uses.

Mansfield said, “Managerial economics is concerned with the application of economic

concepts and economic analysis to the problems of formulating rational managerial decisions.”
Spencer and Siegelman have defined the subject as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”

In other words, economics is the study of the production, distribution, and consumption of
goods and services. It is said to be the study of choice related to the allocation of scarce
resources. Economics includes any business, nonprofit organization, or administrative unit,
hence it is at the core of what managers of these organizations do.

Since the purpose of managerial economics is to apply economics for the improvement of
managerial decisions in an organization, most of the subject material in managerial economics
has a microeconomic focus. However, since managers must consider the state of their
environment in making decisions and the environment includes the overall economy, an
understanding of how to interpret and forecast macroeconomic measures is useful in making
managerial decisions.
NATURE AND SCOPE OF MANAGERIAL ECONOMICS

The scope of managerial economics is a continual process, as it is a developing science.

Demand analysis and forecasting, profit management, and capital management are also
considered under the scope of managerial economics.

In managerial economics, the fundamental function is decision making. Managerial

economics entails the entire course of selecting the most suitable action from two or
more alternatives. Its principal function is to make the most profitable use of resources
which are limited such as labor, capital, land etc. A manager is very careful while
taking decisions as the future is uncertain; he ensures that the best possible plans are
made in the most effective manner to achieve the desired objective which is profit
maximization.

Economic theory and economic analysis are used to solve the problems of managerial
economics. Economics basically has two main divisions which are; Micro economics and
Macro economics.

We live in a civilized society whereby we rely on other people to produce and distribute nearly
all the goods and services we need. However, the sources of those goods and services are
usually not other individuals but organizations created for the explicit purpose of producing
and distributing goods and services. Nearly every organization in our society—whether it is a
business, nonprofit entity, or governmental unit—can be viewed as providing a set of goods,
services, or both. The responsibility for overseeing and making decisions for these
organizations is the role of executives and managers.

The nature of managerial economics

The most important function of management in an organisation is decision making and forward
planning. Vijay (2013) states, “Decision making means the process of selecting one action from
two or more alternative courses of action. Forward planning means establishing plans for the
future to carry out the decision so taken.” The problem of choice arises because resources at
the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and
the firm has to make the most profitable use of these resources.

The decision making is made by the executive, whereby he constructs a decision that will
benefit a stet objective. After taking the decision about the particular output, pricing, capital,
raw-materials and power etc., are prepared. Thus, forward planning and decision-making go
hand in hand. A business manager’s task is made difficult by the uncertainty which surrounds
business decision-making. Nobody can predict the future course of business conditions. He
prepares the best possible plans for the future depending on past experience and future outlook
and yet he has to go on revising his plans in the light of new experience to minimise the failure.
“Managers are thus engaged in a continuous process of decision-making through an uncertain
future and the overall problem confronting them is one of adjusting to uncertainty.” Says
Vijay(2013).

When making a decision in an uncertainty framework, economic theory can be, pressed into
service with considerable advantage as it deals with a number of concepts and principles which
can be used to solve or at least throw some light upon the problems of business management.
For instance; profit, demand, cost, pricing, production, competition, business cycles, national
income etc. The way economic analysis can be used towards solving business problems,
constitutes the subject-matter of Managerial Economics. Therefore, in conclusion we can say
that Managerial Economics is both a science and an art.

Scope of Managerial Economics

The scope of managerial economics is a developing science. The following are the divisions
of business economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices

4. Profit Management

5. Capital Management
Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc.,
have also come to be regarded as part of Managerial Economics.

1.Demand Analysis and Forecasting:

A business firm is an economic organisation which is engaged in transforming productive

resources into goods that are to be sold in the market. A major part of managerial decision
making depends on accurate estimates of demand. A forecast of future sales serves as a guide
to management for preparing production schedules and employing resources. It will help
management to maintain or strengthen its market position and profit base. Demand analysis
also identifies a number of other factors influencing the demand for a product. Demand analysis
and forecasting occupies a strategic place in Managerial Economics.

2.Cost and production analysis:

A firm’s profitability depends much on its cost of production. A wise manager would
prepare cost estimates of a range of output, identify the factors causing are cause variations in
cost estimates and choose the cost-minimising output level, taking also into consideration the
degree of uncertainty in production and cost calculations. Production processes are under the
charge of engineers but the business manager is supposed to carry out the production function
analysis in order to avoid wastages of materials and time. Sound pricing practices depend much
on cost control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.

3.Pricing decisions, policies and practices:

Pricing is a very important area of Managerial Economics. In fact, price is the genesis of
the revenue of a firm ad as such the success of a business firm largely depends on the
correctness of the price decisions taken by it. The important aspects dealt with this area are:
Price determination in various market forms, pricing methods, differential pricing, product-line
pricing and price forecasting.

4.Profit management:
 Business firms are generally organized for earning profit and in the long period, it is profit
which provides the chief measure of success of a firm. Economics tells us that profits are the
reward for uncertainty bearing and risk taking. A successful business manager is one who can
form more or less correct estimates of costs and revenues likely to accrue to the firm at different
levels of output. The more successful a manager is in reducing uncertainty, the higher are the
profits earned by him. In fact, profit-planning and profit measurement constitute the most
challenging area of Managerial Economics.

5.Capital management:

The problems relating to firm’s capital investments are perhaps the most complex and
troublesome. Capital management implies planning and control of capital expenditure because
it involves a large sum and moreover the problems in disposing the capital assets off are so
complex that they require considerable time and labour. The main topics dealt with under
capital management are cost of capital, rate of return and selection of projects.

FUNDAMENTAL CONCERPTS

Managerial economics uses a wide variety of economic concepts, tools, and techniques in the
decision-making process. These concepts can be placed in three broad categories:
1. The theory of the firm, which describes how businesses make a variety of decisions
2. The theory of consumer behaviour, which describes decision making by consumers
3. The theory of market structure and pricing, which describes the structure and
characteristics of different market forms under which business firms operate.

Managerial economics, or business economics, is a division of microeconomics that focuses

on applying economic theory directly to businesses. The application of economic theory
through statistical methods helps businesses make decisions and determine strategy on pricing,
operations, risk, investments and production. The overall role of managerial economics is to
increase the efficiency of decision making in businesses to increase profit.

Pricing
Managerial economics assists businesses in determining pricing strategies and appropriate
pricing levels for their products and services. Some common analysis methods are price
discrimination, value-based pricing and cost-plus pricing.

Elastic vs. Inelastic Goods

Economists can determine price sensitivity of products through a price elasticity analysis. Some
products, such as milk, are consider a necessity rather than a luxury and will purchase at most
price points. This type of product is considered inelastic. When a business knows they are
selling an inelastic good, they can make marketing and pricing decisions easier.

Operations and Production

Managerial economics uses quantitative methods to analyse production and operational

efficiency through schedule optimization, economies of scale and resource analyses.
Additional analysis methods include marginal cost, marginal revenue and operating leverage.
Through tweaking the operations and production of a company, profits rise as costs decline.

Investments

Many managerial economic tools and analysis models are used to help make investing
decisions both for corporations and savvy individual investors. These tools are use to make
stock market investing decisions and decisions on capital investments for a business. For
example, managerial economic theory can be used to help a company decide between
purchasing, building or leasing operational equipment.

Risk

Uncertainty exits in every business and managerial economics can help reduce risk through
uncertainty model analysis and decision-theory analysis. Heavy use of statistical probability
theory helps provide potential scenarios for businesses to use when making decisions.

MICRO AND MACRO ENVIRONMENT

Managerial economics covers both as well as microeconomics, as both are equally

important for decision making and business analysis.

Microeconomics
 • The study of an individual consumer or a firm is called microeconomics.

• Micro means ‘one millionth’.

• Microeconomics deals with behavior and problems of single individual and of micro
organization.

• It is concerned with the application of the concepts such as price theory, Law of
Demand and theories of market structure and so on.

• Microeconomics demand and supply between individuals consumers, buyers, vendors,

providers.

• Microeconomics includes the analysis of small individual units of economy such

as individual firms, individual industry, or a single individual consumer. All the
economic theories, tools, and concepts are covered under the scope of managerial
economics to analyze the business environment.

Macroeconomics

• The study of ‘aggregate’ or total level of economic activity in a country is called

macroeconomics.

• It studies the flow of economics resources or factors of production (such as land, labor,
capital, organization and technology) from the resource owner to the business firms and
then from the business firms to the households.

• It is concerned with the level of employment in the economy.

• It discusses aggregate consumption, aggregate investment, price level, and payment,

theories of employment, and so on.

• Macroeconomics is the total economic environment Studies related to national, local,

regional and global economies.

• Macroeconomics deals with the study of entire economy. It considers all the
factors such as government policies, business cycles, national income, and so on.
BASIC TECHNIQUES OF MANAGERIAL DECISION-MAKING

Decision making is crucial for running a business enterprise which faces a large number of
problems requiring decisions.

Which product to be produced, what price to be charged, what quantity of the product to be
produced, what and how much advertisement expenditure to be made to promote the sales, how
much investment expenditure to be incurred are some of the problems which require decisions
to be made by managers.

1. Setting the Objective:

The first step in the decision making process is to establish the objective of the business
enterprise. The important objective of a private business enterprise is to maximise profits.
However, a business firm may have some other objectives such as maximisation of sales or
growth of the firm.

But the objective of a public enterprise is normally not of maximisation of profits but to follow
benefit-cost criterion. According to this criterion, a public enterprise should evaluate all social
costs and benefits when making a decision whether to build an airport, a power plant, a steel
plant, etc.

2. Defining the Problem:

The second step in decision making process is one of defining or identifying the problem.
Defining the nature of the problem is important because decision making is after all meant for
solution of the problem. For instance, a cotton textile firm may find that its profits are declining.

It needs to be investigated what are the causes of the problem of decreasing profits. Whether it
is the wrong pricing policy, bad labour-management relations or the use of outdated technology
which is causing the problem of declining profits. Once the source or reason for falling profits
has been found, the problem has been identified and defined.

3. Identifying Possible Alternative Solutions (i.e. Alternative Courses of Action):

Once the problem has been identified, the next step is to find out alternative solutions to the
problem. This will require considering the variables that have an impact on the problem. In this
way, relationship among the variables and with the problems has to be established.
In regard to this, various hypotheses can be developed which will become alternative courses
for the solution of the problem. For example, in case of the problem mentioned above, if it is
identified that the problem of declining profits is due to be use of technologically inefficient
and outdated machinery in production

4. Evaluating Alternative Courses of Action:

The next step in business decision making is to evaluate the alternative courses of action. This
requires, the collection and analysis of the relevant data. Some data will be available within the
various departments of the firm itself, the other may be obtained from the industry and
government.

The data and information so obtained can be used to evaluate the outcome or results expected
from each possible course of action. Methods such as regression analysis, differential calculus,
linear programming, cost- benefit analysis are used to arrive at the optimal course. The
optimum solution will be one that helps to achieve the established objective of the firm. The
course of action which is optimum will be actually chosen. It may be further noted that for the
choice of an optimal solution to the problem, a manager works under certain constraints.

The constraints may be legal such as laws regarding pollution and disposal of harmful wastes;
they way be financial (i.e. limited financial resources); they may relate to the availability of
physical infrastructure and raw materials, and they may be technological in nature which set
limits to the possible output to be produced per unit of time. The crucial role of a business
manager is to determine optimal course of action and he has to make a decision under these
constraints.

5. Implementing the Decision:

After the alternative courses of action have been evaluated and optimal course of action
selected, the final step is to implement the decision. The implementation of the decision
requires constant monitoring so that expected results from the optimal course of action are
obtained. Thus, if it is found that expected results are not forthcoming due to the wrong
implementation of the decision, then corrective measures should be taken.

However, it should be noted that once a course of action is implemented to achieve the
established objective, changes in it may become necessary from time to time in response in
changes in conditions or firm’s operating environment on the basis of which decisions were
taken.

6. Follow-Up and Control

The "Follow-up and Control" step is essential to ensure that an implemented decision meets its
objective. The performance is measured by observing the implemented decision in relation to
its standard derived from the objective. Unacceptable variance from standard performance I
should elicit timely and appropriate corrective actions. Corrective actions may result in the
implementation of another alternative, which, if not successful, may result in a revision of the
original objective.

The process is another six step process with mostly action descriptions, the one voiced as a
noun is using the noun "act". So this is a real process and it includes feedback loops within the
process to improve the decision making, if the straight forward step process is not leading to
the right results.

APPLICATION OF ECONOMIC THEORIES IN DECISION-MAKING

▪ Managerial economics provides production and marketing rules that permit a

company to maximize net profits once it has achieved growth objectives.

▪ It has applications in both profit and not-for-profit sectors such as government agencies,
cooperatives, schools, hospitals, museums and similar institutions. For example, an
administrator of a non-profit hospital strives to provide the best medical care possible
given limited medical staff, equipment, and related resources. Using the tools and
concepts of managerial economics, the administrator can determine the optimal
allocation of these limited resources.

▪ It describes the logic of this pricing practice with respect to the goal of profit
maximization.

In short, managerial economics helps managers arrive at a set of operating rules that aid in the
efficient use of scarce human and capital resources. By following these rules, businesses, non-
profit organizations, and government agencies are able to meet objectives efficiently. To
establish appropriate decision rules, managers must understand the economic environment in
which they operate.

NATURE OF THE FIRM

A firm is an association of individuals who have organized themselves for the purpose of
turning inputs into output. The firm organizes the factors of production to produce goods and
services to fulfil the needs of the households. Each firm lays down its own objectives which is
fundamental to the existence of a firm.

The major objectives of the firm are:

• To achieve the Organizational Goal
• To maximize the Output
• To maximize the Sales
• To maximize the Profit of the Organization
• To maximize the Customer and Stakeholders Satisfaction
• To maximize Shareholder’s Return on Investment
• To maximize the Growth of the Organization
•
Firms are established to earn profit, to keep the shareholders happy. To increase their market
share, they try to maximize their sales. In the present business world firms try to produce goods
and services without harming the environment. Firms are not always able to operate at a profit.
They may be facing the operating loss also. Economists believe that firms maximize their long
run rather than their short run profit. So managers have to make enough profit to satisfy the
demands of their shareholders and to maximize their wealth through the company
“The Nature of the Firm” (1937), is an article by Ronald Coase. It offered an economic
explanation of why individuals choose to form partnerships, companies and other business
entities rather than trading bilaterally through contracts on a market.

FORMS OF ORGANISATION
1. Sole Proprietorship

A sole proprietorship is when there is a single founder who owns and runs the business. This
is the simplest form of business entity because the business is not separate from the owner.

You can give your business a trading name, and only you have the authority to make decisions
about your business.

Advantages of a sole proprietorship

There are quite a few advantages of sole proprietorship, such as:

• It’s easier to set up than any of the other business entities.

• The owner maintains 100% control and ownership of the business.

• The owner is entitled to all of the profits.

Disadvantages of a sole proprietorship

• You, as the owner, assume all the risk for the business. Your assets will be seized to
pay for business debt, and you are personally liable for any obligations.

• If you wish to include another owner in your business, you’ll have to dissolve the sole
proprietorship and form a new business entity.

2. Partnership

A partnership is when two or more co-owners run a business together. Partners will also pool
their money towards a common goal, share specialised skills and resources and share in the ups
and downs of business success.

Advantages of having a partner

• With more people comes more knowledge and expertise

• You’ll have more capital and cash to work with.

• You can share the financial burden and expenses of running a business with your fellow
partners.

• Having partners means there is an even distribution of labour.

• You’ll have a better work-life balance as there are others to assist you with the
workload? and ensuring your business is becoming a success.

Disadvantages of having a partner

• Everyone is liable for debts whether they were caused by other partners or not.
 • You have to share control of the business with your partner(s)

• Dealing with others is not always seamless, there could be a falling out or an argument,
which can strain the relationship between you and your partner.

• If you ever want to sell your business, this could prove difficult if others don’t want to
sell.

3. Pty Ltd - Proprietary limited company

A private company, Pty Ltd or proprietary limited company is treated as a separate legal entity.
So even if you launch your business single-handedly, this type of business is registered as
a separate legal entity. The owners of a Pty Ltd are also known as the shareholders.

Advantage of being a Pty Ltd

• You don’t have to explain your finances and decisions to anyone. This is the reason
Richard Branson took his company private again after having it public for two years.

• The business is a separate entity, so it continues to run smoothly even if you sell your
shares or take on partners.

• Shareholders are typically not liable for company debts, although there are some tax
liabilities.

• Anyone acting recklessly or fraudulently can be personally liable for all or any debts of
the Pty Ltd.

Disadvantages of being a Pty Ltd

• Private companies are required to comply with a large number of legal requirements.

• This type of business is challenging and expensive to register.

• As this is a private company, you can’t offer shares to the public or list the business on
a stock exchange.

• Two shareholders must be at a meeting, except when the company only has one
shareholder

• All of your financial statements need to undergo annual auditing.

4. Public Company

A public company is a business that issues securities through an initial public offering (IPO)
and trades its stock on at least one stock exchange. The daily trading of the public company’s
stock determines the value of the whole business.

Publicly traded companies are defined as public because, unlike Pty Ltd businesses,
shareholders can be anyone who purchases stock. Anyone can then become equity owners of
the business.

Advantage of publicly traded companies

• Since you can sell your shares to the public, this offers you more capital to work with.

• Being listed on a stock exchange means that fund managers and traders are keeping an
eye on your business. The more interest you have, the more business opportunities will
come your way.

• The risk is spread out amongst the various shareholders. The more shareholders, the
less risk everyone holds.

Disadvantages of publicly traded companies:

• Setting up a public company is more challenging compared to the other types of

business structures.

• Since there are now more shareholders, directors and managers, making decisions can
take significantly longer.

• You’ll need to reveal some of your documents and annual accounts are published for
inspection to the public. This improves transparency but doesn’t enable you to guard
your secrets effectively.

• When you go public, you’re selling the ownership of your company to strangers. It’s
challenging to raise the money you need while keeping a 51% majority.

5. Franchise

A franchise is when the owner of a business licenses their business to a third party. This gives
you the right to operate the business or distribute goods and/or services using the business’s
name and systems, for a fee.
Advantage of operating a franchise

• Typically, a franchise has a successful track record and a positive reputation that you
can capitalise on.

• Franchises offer training programmes designed to optimise how you run the business
and bring you up to speed quickly.

• If you join a franchise, they also offer ongoing operational support. This ensures you’re
not alone when building and growing your business.

Disadvantages of operating as a franchise

• If you’ve bought into a franchise, you’ll have to follow the rules, regulations, system
operations and directives of the franchise.

• The cost of becoming a franchisee can be high, sometimes even higher than starting
your own business.

• You’ll have to pay royalties to the franchise for the use of their name and systems.

STRUCTURES AND SECTORS OF INDIAN ECONOMY

According to Drishti (2019), there are three sectors in the Indian economy, they are; primary
economy, secondary economy, and tertiary economy. In terms of operations, the Indian
economy is divided into organized and unorganized. While for ownership, it is divided into the
public sector and the private sector. But today, we are only going to talk about the sectors of
Indian economy and what consists of these sectors.

Primary Sector

The primary sector in India is the sector which is largely dependant on the availability of natural
resources in order to manufacture the goods and also to execute various processes. The services
in this sector are entirely dependant on the availability of the natural resources in order to keep
the day-to-day operations running.

As we have the clear idea of this sector is, the best example to discuss in this sector is the
agriculture sector. The other examples in this sector include fishing and forestry, but agriculture
accounts for the largest in this sector.
One of the major problem that this sector faces is the underemployment and the disguised
employment. Underemployment accounts for the workers not working to the best of their
capabilities while the latter accounts for the workers not working to their true potential.

As a solution to the problems, the state, as well as the national government, can increase the
funds for the irrigation facilities and provide loans for buying high-quality seeds and fertilizers.

Secondary Sector

The economy in the sector is dependent on the natural ingredients which are used to create the
services and products offered and which at the end are used for consumption. In terms of value
added to the products and services, this sector is the best sector. The major examples that fall
under this category are transportation and manufacturing.

Both these sectors end product is the consumption by the people. This sector is responsible for
the employment of almost 14 percent of the entire workforce currently working in India. The
secondary sector also contributes to almost 28 percent of the share of GDP. This sector is the
backbone of Indian economy and there are more development and growth in the near future.

Tertiary Sector

This sector contributes the largest in terms of share in GDP in India. The sector is also the service
sector and is important when you consider the development of the other two sectors. Like the
previous sector, this sector also adds the value to the products. This sector is responsible for
employing 23 percentage of the workforce out of the total workforce currently working in India.

The example of this sector is all service sectors which IT services, consulting, etc. This sector
contributes to almost 59 percent of the total share of GDP. The main problem that this sector is
that the jobs which involve lower salaries do not attract much employment. And this remains
the future dilemma as India is looking for double-digit growth in the near future.
MODULE 2
UTILITY
MEANING OF UTILITY
Utility in economics is defined as the absolute pleasure and contentment that is acquired by a
consumer from consuming a good or service. A consumer’s utility is believed to be impractical
in terms of measuring and evaluating, therefore it is fundamental to know the economic utility
of goods and services as it has a direct impact on demand and the price of such goods and
services. Nevertheless, some economists trust that the utility of an economic good or service
can be secondarily estimated by making use of several models. Utility is measured in utils.

TOTAL AND MARGINAL UTILITY

Total utility is the components of utility that is presented in numerical form, that a consumer
attains from consuming a given amount of good or service in the course of a specific period of
time. The higher a consumer’s total utility, the greater the degree of contentment of a consumer.

Marginal utility is an extra pleasure that a consumer gains from using a few units of goods
and services. This concept of marginal utility is employed by economists to find out how much
of an item a consumer is prepared to buy. A constructive marginal utility takes place when the
utilization of an auxiliary unit expands the total utility. In contrast, a negative marginal utility
occurs when the use of a few units decline the general utility.

MAJOR TYPES OF UTILITY

1. FORM UTILITY: It is fashioned by the composition of the product itself. When
goods and services are accurately chosen according to the consumer’s desires and
needs, their form utility becomes an elevated quality. In other words, form utility is
attained by modifying consumer’s necessities into goods and services. Most companies
study their target markets and also observe their prospective consumers to find out what
they need, then use their findings to align the features of their products with what
consumers actually want. Form utility is therefore constructed via the essentials such
as high quality materials, user-friendly designs, or a wide selection of options to choose
from.

2. PLACE UTILITY: It is obtained through the process of making goods and services
more easily available to potential consumers. The easier it is to purchase a product, the
 more attractive it becomes, and thus, place utility has a lot to do with distribution
channels and the physical locations where goods and services are sold. Some people
argue that even stuff such as the noticeable products on the internet affects place utility.
After all, a wide variety of goods and services can be purchased online nowadays.

3. TIME UTILITY: This type of utility is employed by providing consumers with an

easy way to access goods and services any time they need and want such products. The
more easily and quickly a product can be bought and used on time, the higher the
perceived time utility. Time utility is said to be high in times of scarcity, hence, the
supply chain management of a company has a significant impact on time utility. Among
others, this includes processes such as logistics, delivery and storage.

4. POSSESSION UTILITY: It describes the benefits that can be derived from owning
and using a specific good or service. Generally speaking, the more useful goods and
services are to consumers, the higher the possession utility. In some cases, especially
according to marketing theory, the term possession utility is also used in the context of
facilitating possession, that is, through the use of easy payment methods like credit
cards and leasing contracts. The reason behind this is that, a simpler acquisition process
usually leads to a higher perceived value of goods and services.

UTILITY ANALYSIS
Utility analysis is a quantitative method which approximates the worth of a dollar that is
generated by an intervention based on the improvements that are produced in worker
productivity. It represent a category of consumer demand theory that explores consumer
behavior and market demand using total and marginal utility. The fundamental concept of
utility analysis is the law of diminishing marginal utility, which puts forward, the clarification
for the law of demand and the negative slope of the demand curve. Utility analysis gives
managers an important information that they can use to evaluate the financial impact of an
intervention, including computing a return on their investment in implementing it. It also
provides some insights into an understanding of market demand and forms of cornerstone of
modern microeconomics.

The most important focus of utility analysis is based on pleasure a consumer gets from
consuming goods and services. The satisfaction that is gained from the consumption of goods
and services affects the decision to purchase and consume those goods and services. In
particular, this analysis investigates consumer behavior, more especially market purchases
which is based on the utility generated from the use of goods and services. When used in the
analysis of consumer behavior, utility assumes a very precise meaning, which differs from the
daily use.

EQUILIBRIUM OF THE CONSUMER

Equilibrium of a consumer is a situation in which a consumer derives maximum satisfaction

with no intention to change it and subject to given prices and his or her given income. The
point of maximum satisfaction is achieved by studying the indifference map and budget line
together. A consumer is said to be in equilibrium when he or she cannot modify his or her
circumstances by earning or spending more, or by changing the quantity of goods and services
that he or she buys. A reasonable customer purchases a good or service up to the point where
its price is equivalent to the marginal utility gained from consuming such products.

The consumer’s equilibrium is a state of balance obtained by an end user of products that refers
to the number of goods and services that they can buy, given their existing level of income and
the prevailing level of cost-prices. Consumer equilibrium permits a consumer to get the most
satisfaction possible from their income. If the consumer equilibrium is not fulfilled, the
consumer’s purchase will either be less or more and if the purchase is more, the marginal utility
will fall hence a situation will develop whereby price paid will exceed marginal utility. In order
to avoid negative utility, the consumer will have to reduce the consumption and marginal utility
will increase.

When the consumers make about the quantity of goods and services to consume, it is presumed
that their objective is to maximize the total utility. In maximizing total utility, a consumer faces
some constraints such as, their income and the price of goods and services that they wish to
consume. The consumer’s efforts to maximize total utility, in relation to the mentioned
constraints is classified as the consumer’s problem. The solution to this problem, which entails
the decisions about how much the consumer will use in terms of quantity, is referred to as
consumer equilibrium.

INDIFFERENCE CURVE
Indifference curve is defined as a graph demonstrating a combination of two goods that equally
satisfy a consumer, as well as the utility. Each point on an indifference curve shows that a
consumer is indifferent between the two goods, and all the points grants him or her the same
utility. Indifference curve is drawn as the downward sloping convex to the origin. The graph
shows the combination of two goods that a consumer consumes.

Graphical representation

The diagram shows an Indifference curve (IC). Any combination lying on this curve gives the
same level of consumer satisfaction. Another name for it is Iso-Utility Curve.

Indifference Map

An Indifference Map is a set of Indifference Curves. It depicts the complete picture of a

consumer’s preferences. The following diagram showing an indifference map consisting of

three curves:
We know that a consumer is indifferent among the combinations lying on the same indifference
curve. However, it is important to note that he prefers the combinations on the higher
indifference curves to those on the lower ones. This is because a higher indifference curve
implies a higher level of satisfaction. Therefore, all combinations on IC1 offer the same
satisfaction, but all combinations on IC2 give greater satisfaction than those on IC1.

PROPERTIES OF THE INDIFFERENCE CURVE:

• An IC slopes downwards to the right

• This slope signifies that when the quantity of one commodity in combination is
increased, the amount of the other commodity reduces. This is essential for the level of
satisfaction to remain the same on an indifference curve.
• An IC is always convex to the origin
• From our discussion above, we understand that as Peter substitutes clothing for food,
he is willing to part with less and less clothing. This is the diminishing marginal rate of
substitution. The rate gives a convex shape to the indifference curve. However, there
are two extreme scenarios:
• Two commodities are perfect substitutes for each other – In this case, the indifference
curve is a straight line, where MRS is constant.
• Two goods are perfect complementary goods – An example of such goods would be
gasoline and water in a car. In such cases, the IC will be L-shaped and convex to the
origin.
• Indifference curves never intersect each other
• Two ICs will never intersect each other. Also, they need not be parallel to each other
either. Look at the following diagram:
Fig 3 shows two ICs intersecting each other at point A. Since points A and B lie on IC1, they
give the same satisfaction level to an individual. Similarly, points A and C give the same
satisfaction level, as they lie on IC2. Therefore, we can imply that B and C offer the same level
of satisfaction, which is logically absurd. Hence, no two ICs can touch or intersect each other.

• A higher IC indicates a higher level of satisfaction as compared to a lower IC

• A higher IC means that a consumer prefers more goods than not.

• An IC does not touch the axis
• This is not possible because of our assumption that a consumer considers different
combinations of two commodities and wants both of them. If the curve touches either
of the axes, then it means that he is satisfied with only one commodity and does not
want the other, which is contrary to our assumption.
BUDGET LINE

Since a higher indifference curve represents a higher level of satisfaction, a consumer will try
to reach the highest possible IC to maximize his satisfaction. In order to do so, he has to buy
more goods and has to work under the following two constraints:

• He has to pay the price for the goods and

 • He has limited income, restricting the availability of money for purchasing these goods

As can be seen above, a budget line shows all possible combinations of two goods that a
consumer can buy within the funds available to him at the given prices of the goods. All
combinations that are within his reach lie on the budget line. A point that is outside the line
(point H) represents a combination beyond the financial reach of the consumer. On the other
hand, a point inside the line (point K) represents under-spending by the consumer.

What are the assumptions underlying the indifference curve approach?

• The consumer is rational. Also, he possesses full information about all the relevant
aspects of the economic environment in which he lives.

• The consumer can rank combination of goods based on the satisfaction they yield.
However, he can’t quantitatively express how much he prefers a certain good over the
other.
• If a consumer prefers A over B and B over C, then he prefers A over C.
• If a combination X has more commodities than the combination Y, then X is preferred
over Y.

INDIFFERENCE CURVE ANALYSIS

Indifference curves work under numerous assumptions, for example, typically each
indifference curve is convex to the origin and there is no way two indifference curves can
intersect. It is assumed that consumers are more content when they achieve bundles of goods
in indifference curves that are further from the origin. When the income of a consumer
increases, the consumer will typically shift their consumption level because they can now
afford more goods and services, with the result that they will end up in an indifference curve
that is further from the origin, hence better-off.

Many core principles of microeconomics appear in indifference curves analysis, including

individual choice, marginal utility theory, income, substitution effects and the subjective theory
of value. Indifference curve analysis emphasizes the Marginal Rates of Substitution (MRS) and
opportunity costs. All other economic variables and possible complications are treated as stable
or ignored unless they are placed on indifference graph.

Most books of economics are built upon indifference curve to introduce the optimal choice of
the consumer on goods and services based on their income. Classic analysis suggests that the
optimal consumption bundle takes place at the point where a consumer’s indifference curve is
tangent with their budget constrained. The slope of an indifference curve is known as MRS.
The MRS is defined as the rate at which the consumer will be slower to give up one good for
another. For instance, if a consumer likes apples, he or she will be slower to give them up for
some oranges, therefore the slope will reflect this rate of substitution.

DEMAND
MEANING OF DEMAND
Demand means the willingness and ability of consumers to purchase a given quantity of goods
and services at a given point of time or over a certain period of time. In economics, demand
refers to the needs and wants of consumers supported by their ability to pay, namely, a budget
derived from disposable income. When people have some income, they get the power to buy
commodities, and this power is exercised in a market through effective demand.

Economic demand is a principle that refers to a consumer’s demand for a particular product, as
well as the price they are willing to pay for that product. While demand is highly variable due
to outside factors, the basic concept is that economic demand will decrease as price increases.

DEMAND CURVE
A demand curve is a graphical representation of the relationship between the demand price and
quantity of commodities demanded. It is drawn with the price on the vertical axis and quantity
demanded on the horizontal axis. With few exceptions, the demand curve is delineated as
sloping downward from left to right because price and quantity demanded are inversely related.
This means that, the lower the price of a product, the higher the demand or number of sales.
This relationship is contingent on certain ceteris paribus (other things equal) conditions
remaining constant. Such conditions include the number of consumers in the market, their
tastes and preference, price of substitute goods, their price expectations and personal income.
A change in one or more of these conditions causes a change in demand, which is reflected by
a shift in the location of a demand curve. A shift to the left indicates that there is a decrease in
demand, while a movement to the right means an increase.

As a graphical representation, the demand curve slopes downward from left to right, indicating
low demand at high prices and high demand at low prices. The economic demand curve is
inverse to the supply curve, which slopes upward from left to right, showing an increase in
supply as the price gets higher. This is due to the fact that businesses will produce more of a
product or item when it leads to increased profitability.

LAW OF DEMAND
Law of demand is the inverse relationship between demand price and the quantity demanded,
ceteris paribus. This fundamental economic principle indicates that as the price of a product
falls, then the quantity of such commodity that a consumer is willing to buy at the given period
of time, if other factors are held constant, increases. This law is incredibly important to the
study of economics.

The explanation of the law of demand using utility analysis is relatively simple. Consumers
buy goods and services that satisfy their wants and needs, that is, generate utility. Those
commodities that generate more utility are more valuable to consumers and thus they are
willing to buy at a higher price. The key to the law of demand is that the utility generated
declines as the quantity consumed increases. As such, the demand price that consumers are
paying decreases as the quantity demanded increases.

DETERMINANTS OF DEMAND
1. Consumer’s expectations: Expectations play a massive role in economic demand. To
illustrate this, in housing prices, a consumer will buy a home and continue to buy it at
the current price, even if it’s rising daily, if they expect the price to rise in future. In
their minds they are getting more value for their home by buying it at the current price
and letting it grow in value. The same can be said for falling prices, but conversely. If
 the price of a house is falling, a consumer is less likely to buy, as they believe the price
will continue to fall.

2. Price of a product: with all other factors equal, price is the foremost determinant of
whether consumers purchase a product, that is, economic demand. While outliers exist
that will pay premium prices based on the quality of good, price still remains the most
vital aspect of demand.

3. Price related to goods or services: when the price of goods increases, its demand falls.
The increase in price can affect complementary goods as well. For example, if a
consumer buys a Dell computer and Apple comes out with another computer that
renders the model obsolete, his or her demand as well as others’ demand will fall. The
same idea often happens in the automotive industry. When gas prices rise, the demand
for economical cars increases, while the demand for gas guzzlers falls.

4. Income of the consumer: if the consumer’s income is increased, he or she has more
spending power, meaning they will buy more products. The same is true if their income
decreases, they will have less buying power. Marginal utility is also a concept that is
factored into the link between demand and income. This idea states that consumers will
not buy a proportionate amount of a product compared to their increase in income.

5. Number of buyers in the market: when more buyers are in the market for goods and
services, the demand goes up. This principle is also known as the aggregate demand.

TYPES OF DEMAND
1. Market and individual demand: individual demand is the economic demand for a
product at a certain price by one consumer. Customer tastes, perceived quality and
brand loyalty affect individual demand. Market demand, also known as aggregate
demand, is the total economic demand of all individual demand in particular market.

2. Organizational and industry demand: the demand for a product at a certain price
over a period of time from a single entity is known as company demand. Industry
demand is the total aggregate demand for products in an industry. Company demand is
often expressed as a percentage of industry demand in order to measure market share.
For example, the demand of a Pepsi products is the company demand, but it only makes
up a percentage of the total industry demand for beverages.
3. Short and long term demand: this is the economic demand over a short period of
time. Short term demand is elastic, meaning, it reflects price changes, fads and necessity
more drastically than long-term demand. Instantly, winter clothing is worn during the
cold months, making the demand short-term compared to the clothes that are worn year-
round. Price makes short-term demand to fluctuate drastically. Long-term demand is
the consumers’ demand for products over a longer period of time. This demand does
not change nearly as much with respect to price. Instead, it changes based on promotion
and advertising by a company, the availability of substitutes and competition.

4. Durable and perishable goods demand: durable goods are those that can be used
more than once in their life circle. Perishable goods are the ones that can only be
consumed once. While both types are able to satisfy the demands of consumers, durable
items have more perceived value over the long-term. Again, durable goods also need
replacement over time, so a market demand is still exists for them after an initial
purchase.

5. Autonomous and derived demand: autonomous demand, also known as direct

demand, is when the demand for a product is independent of all other goods in the
market. Derived demand is an economic demand that directly correlates with the
demand for another products. For example, if the demand for tires goes up, the demand
for rubber will increase proportionally.

6. Income demand: income is a determinant of economic demand, so it is easy to

understand why it has its own type of demand. Income demand is the willingness of a
consumer to buy a certain product at a given income level and price. If an income goes
down, demand goes down, and if an income increases, demand will also go up.

7. Price demand: it refers to the quantity of a certain good that a consumer will buy at a
certain price. Unlike income demand, price demand has an inverse relationship between
price and overall demand. As the price goes up, demand falls and vice-versa.

8. Cross demand: this demand centers on the number of substitutes and related products
in a particular market. When the price of a certain product goes up, cross demand
dictates that its substitute will see an increase in demand. For example, if the price of
cow’s milk increases, the demand for almond milk, soy milk and other milk substitute
will increase.
INDIVIDUAL, FIRM AND MARKET DEMAND
The Law of Demand states that when the price of a commodity falls, its demand increases and
when the price of a commodity rises, its demand decreases; other things remaining constant.
Thus, there exists an inverse relationship between price and quantity demanded of a
commodity. The functional relationship between price and quantity demanded can be
represented as Dx = f(Px).

Demand Schedule

It is a statement in the form of a table that shows the different quantities in demand at different
prices. There are two types of Demand Schedules:

• Individual Demand Schedule

• Market Demand Schedule

Individual Demand Schedule: It is a demanding schedule that depicts the demand of an

individual customer for a commodity in relation to its price. Let us study it with the help of an
example.

Thus, we can conclude that as the price falls the demand increases and as the price raises the
demand decreases. Hence, there exists an inverse relationship between the price and quantity
demanded.
Individual Demand Curve: It is a graphical representation of the individual demand schedule.
The X-axis represents the demand and Y-axis represents the price of a commodity.

The above demand curve shows the demand for Gasoline. When the price of gasoline is $3.5
per liter, its demand is 50 liters and when the price is $0.5 per liter, its demand is 250 liters.

Market Demand Schedule: It is a summation of the individual demand schedules and depicts
the demand of different customers for a commodity in relation to its price. Let us study it with
the help of an example.

The above schedule shows the market demand for commodity X. When the price of the
commodity is ₹100, customer A demands 50 units while the customer B demands 70 units.
Thus, the market demand is 120 units. Similarly, when its price is ₹500, Customer A demands
20 units while customer B demands 30 units. Thus, it’s market demand decreases to 40 units.
Thus, we can conclude that whether it is the individual demand or the market demand, the law
of demand governs both of them.
Market Demand Curve: It is a graphical representation of the market demand schedule. The
X-axis represents the market demand in units and Y-axis represents the price of a commodity.

The above schedule shows the market demand for commodity X. When the price of the
commodity is ₹100, customer A demands 50 units while the customer B demands 70 units.

Thus, the market demand is 120 units. Similarly, when its price is ₹500, Customer A demands
20 units while customer B demands 30 units. Thus, its market demand decreases to 40 units.
Thus, we can conclude that whether it is the individual demand or the market demand, the law
of demand governs both of them.

Market Demand Curve: It is a graphical representation of the market demand schedule. The
X-axis represents the market demand in units and Y-axis represents the price of a commodity.

EFFECT
INCOME AND SUBSTITUTION EFFECT
Income Effect vs. Substitution Effect
The income effect expresses the impact of increased purchasing power on consumption, while
the substitution effect describes how consumption is impacted by changing relative income and
prices. These economics concepts express changes in the market and how they impact
consumption patterns for consumer goods and services. Different goods and services
experience these changes in different ways. Some products, called inferior goods, generally
decrease in the consumption whenever incomes increase. Consumer spending and consumption
of normal goods typically increases with higher purchasing power, which is in contrast with
inferior goods.

KEY TAKEAWAYS

• The income effect is the change in the consumption of goods by consumers based on
their income.

• The substitution effect happens when consumers replace cheaper items with more
expensive ones when their financial conditions change.

• The income effect can be both direct (when it is directly related to a change in income)
or indirect (when consumers must make buying decisions not directly related to their
incomes).

• A small reduction in price may make an expensive product more attractive to

consumers, which can also lead to the substitution effect.
Income Effect

The income effect is the change in the consumption of goods based on income. This means
consumers will generally spend more if they experience an increase in income, and they may
spend less if their income drops. But the effect doesn't dictate what kind of goods consumers
will buy. They may opt to purchase more expensive goods in lesser quantities or cheaper goods
in higher quantities, depending on their circumstances and preferences.

The income effect can be both direct and indirect. When a consumer chooses to make changes
to the way he or she spends because of a change in income, the income effect is said to be
direct. For example, a consumer may choose to spend less on clothing because his income has
dropped.

An income effect becomes indirect when a consumer is faced with making buying choices
because of factors not related to her income. For instance, food prices may go up leaving the
consumer with less income to spend on other items. This may force her to cut back on dining
out, resulting in an indirect income effect.

The marginal propensity to consume explains how consumers spend based on income. It is a
concept based on the balance between the spending and saving habits of consumers. The
marginal propensity to consume is included in a larger theory of macroeconomics known
as Keynesian economics. The theory draws comparisons between production, individual
income, and the tendency to spend more of it.

Substitution Effect

The substitution may occur when a consumer replaces cheaper or moderately priced items with
ones that are more expensive when a change in finances occurs. For example, a good return on
an investment or other monetary gains may prompt a consumer to replace the older model of
an expensive item for a newer one.

The inverse is true when incomes decrease. Substitution in the direction of buying lower-priced
items has a generally negative consequence on retailers because it means lower profits. It also
means fewer options for the consumer.

Retailers who generally sell cheaper items typically benefit from the substitution effect.

While the substitution effect changes consumption patterns in favour of the more affordable
alternative, even a modest reduction in price may make a more expensive product more
attractive to consumers. For instance, if private college tuition is more expensive than public
college tuition and money is a concern, consumers will naturally be attracted to public colleges.
But a small decrease in private tuition costs may be enough to motivate more students to begin
attending private schools.

The substitution effect is not just limited to consumers. When companies outsource part of their
operations, they are using the substitution effect. Using cheaper labour in a different country
or by hiring a third party results in a drop in costs. This nets a positive result for the corporation,
but a negative effect for the employees who may be replaced.

PRICE EFFECT
The price effect is a concept that looks at the effect of market prices on consumer demand. The
price effect can be an important analysis for businesses in setting the offering price of their
goods and services. In general, when prices rise, buyers will typically buy less and vice versa
when prices fall. This is demonstrated by a standard price to demand curve.

Price Effect Calculations

A demand curve plots the price on the y-axis and demand quantity on the x-axis. The shape is
typically downward sloping. Price elasticity of demand describes the expected change in
demand per price change. The demand curve can be important for businesses in understanding
the potential effects of a price increase or decrease in their offerings.

The Price Effect: The price effect indicates the way the consumer’s purchases of good X
change, when its price changes, A given his income, tastes and preferences and the price of
good Y. This is shown in Figure 12.18. Suppose the price of X falls. The budget line PQ will
extend further out to the right as PQ1, showing that the consumer will buy more X than before
as X has become cheaper. The budget line PQ2 shows a further fall in the price of X. Any rise
in the price of X will be represented by the budget line being drawn inward to the left of the
original budget line towards the origin.
If we regard PQ2, as the original budget line, a two time rise in the price of X will lead to the
shifting of the budget line to PQ1, and PQ2. Each of the budget lines fanning out from P is a
tangent to an indifference curve I1, I2, and I3 at R, S and T respectively. The curve PCC
connecting the locus of these equilibrium points is called the price- consumption curve. The
price-consumption curve indicates the price effect of a change in the price of X on the
consumer’s purchases of the two goods X and Y, given his income, tastes, preferences and the
price of good Y.

ELASTICITY
ELASTICITY MEASURES
Elasticity is a measure of a variable's sensitivity to a change in another variable, most
commonly this sensitivity is the change in price relative to changes in other factors. In business
and economics, elasticity refers to the degree to which individuals, consumers or producers
change their demand or the amount supplied in response to price or income changes. It is
predominantly used to assess the change in consumer demand as a result of a change in a good
or service's price.

How Elasticity Works

When the value of elasticity is greater than 1.0, it suggests that the demand for the good or
service is affected by the price. A value that is less than 1.0 suggests that the demand is
insensitive to price, or inelastic. Inelastic means that when the price goes up, consumers’
buying habits stay about the same, and when the price goes down, consumers’ buying habits
also remain unchanged. If elasticity is zero it is known as perfectly inelastic. If elasticity = 0,
then it is said to be 'perfectly' inelastic, meaning its demand will remain unchanged at any price.
There are probably no real-world examples of perfectly inelastic goods. If there were, that
means producers and suppliers would be able to charge whatever they felt like and consumers
would still need to buy them. The only thing close to a perfectly inelastic good would be air
and water, which no one controls.

Elasticity is an economic concept used to measure the change in the aggregate quantity
demanded for a good or service in relation to price movements of that good or service. A
product is considered to be elastic if the quantity demand of the product changes drastically
when its price increases or decreases. Conversely, a product is considered to be inelastic if the
quantity demand of the product changes very little when its price fluctuates. For example,
insulin is a product that is highly inelastic. For diabetics who need insulin, the demand is so
great that price increases have very little effect on the quantity demanded. Price decreases also
do not affect the quantity demanded; most of those who need insulin aren't holding out for a
lower price and are already making purchases.

On the other side of the equation are highly elastic products. Bouncy balls, for example, are
highly elastic in that they aren't a necessary good, and consumers will only decide to make a
purchase if the price is low. Therefore, if the price of bouncy balls increases, the quantity
demanded will greatly decrease, and if the price decreases, the quantity demanded will
increase.

Types of Elasticity

1. Demand elasticity is an economic measure of the sensitivity of demand relative to a

change in another variable. The quantity demanded of a good or service depends on
multiple factors, such as price, income and preference. Whenever there is a change in
these variables, it causes a change in the quantity demanded of the good or service. For
example, when there is a relationship between the change in the quantity demanded and
the price of a good or service, the elasticity is known as price elasticity of demand. The
two other main types of demand elasticity are income elasticity of demand and cross
elasticity of demand.

2. Income elasticity of demand refers to the sensitivity of the quantity demanded for a
certain good to a change in real income of consumers who buy this good, keeping all
other things constant. The formula for calculating income elasticity of demand is the
percent change in quantity demanded divided by the percent change in income. With
income elasticity of demand, you can tell if a particular good represents a necessity or
a luxury.

3. The cross elasticity of demand is an economic concept that measures the

responsiveness in the quantity demanded of one good when the price for another good
changes. Also called cross-price elasticity of demand, this measurement is calculated
by taking the percentage change in the quantity demanded of one good and dividing it
by the percentage change in the price of the other good.
 4. Price elasticity of supply measures the responsiveness to the supply of a good or
service after a change in its market price. According to basic economic theory, the
supply of a good will increase when its price rises. Conversely, the supply of a good
will decrease when its price decreases

Factors Affecting Demand Elasticity

There are three main factors that influence a good’s price elasticity of demand:

1. Availability of Substitutes: In general, the better substitutes there are, the more
elastic the demand will be. For example, if the price of a cup of coffee went up by
$0.25, consumers might replace their morning caffeine fix with a cup of strong tea.
This means that coffee is an elastic good because a small increase in price will cause
a large decrease in demand as consumers start buying more tea instead of coffee.
However, if the price of caffeine itself were to go up, we would probably see little
change in the consumption of coffee or tea because there may be few good substitutes
for caffeine. Most people, in this case, might not willingly give up their morning cup
of caffeine no matter what the price. We would say, therefore, that caffeine is an
inelastic product. While a specific product within an industry can be elastic due to the
availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique
goods such as diamonds are inelastic because they have few if any substitutes.

2. Necessity: As we saw above, if something is needed for survival or comfort, people

will continue to pay higher prices for it. For example, people need to get to work or
drive for a number of reasons. Therefore, even if the price of gas doubles or even
triples, people will still need to fill up their tanks.

3. Time: The third influential factor is time. If the price of cigarettes goes up to $2 per
pack, a smoker with very few available substitutes will most likely continue buying
his or her daily cigarettes. This means that tobacco is inelastic because the change in
price will not have a significant influence on the quantity demanded. However, if that
smoker finds that he or she cannot afford to spend the extra $2 per day and begins to
kick the habit over a period of time, the price elasticity of cigarettes for that consumer
becomes elastic in the long run.
The Importance of Price Elasticity in Business

Understanding whether or not a business's good or service is elastic is integral to the success
of the company. Companies with high elasticity ultimately compete with other businesses on
price and are required to have a high volume of sales transactions to remain solvent. Firms that
are inelastic, on the other hand, have goods and services that are must-haves and enjoy the
luxury of setting higher prices.

Beyond prices, the elasticity of a good or service directly affects the customer retention rates
of a company. Businesses often strive to sell goods or services that have inelastic demand;
doing so means that customers will remain loyal and continue to purchase the good or service
even in the face of a price increase.

The Importance of Price Elasticity in Business

Understanding whether or not a business's good or service is elastic is integral to the success
of the company. Companies with high elasticity ultimately compete with other businesses on
price and are required to have a high volume of sales transactions to remain solvent. Firms that
are inelastic, on the other hand, have goods and services that are must-haves and enjoy the
luxury of setting higher prices.

Beyond prices, the elasticity of a good or service directly affects the customer retention rates
of a company. Businesses often strive to sell goods or services that have inelastic demand;
doing so means that customers will remain loyal and continue to purchase the good or service
even in the face of a price increase.

Examples of Price Elasticity of Demand

Generally as rules of thumb, if the quantity of a good demanded or purchased changes more
than the price change, the product is termed elastic. (The price changes by +5%, but the demand
falls by -10%). If the change in quantity purchased is the same as the price change (say,
10%/10% = 1), the product is said to have unit (or unitary) price elasticity. Finally, if the
quantity purchased changes less than the price (say, -5% demanded for a +10% change in
price), then the product is termed inelastic.

To calculate the elasticity of demand, let's take a very simple example: Suppose that the price
of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers
increase their apple purchases by 20%. The elasticity of apples would thus be: 0.20/0.06 = 3.33
indicating that apples are quite elastic in terms of their demand.

ELASTICITY OF DEMAND
Demand elasticity is an economic measure of the sensitivity of demand relative to a change in
another variable. The quantity demanded of a good or service depends on multiple factors, such
as price, income and preference. Whenever there is a change in these variables, it causes a
change in the quantity demanded of the good or service. For example, when there is a
relationship between the change in the quantity demanded and the price of a good or service,
the elasticity is known as price elasticity of demand.

The two other main types of demand elasticity are income elasticity of demand and cross
elasticity of demand.

Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain
good to a change in real income of consumers who buy this good, keeping all other things
constant. The formula for calculating income elasticity of demand is the percent change in
quantity demanded divided by the percent change in income. With income elasticity of demand,
you can tell if a particular good represents a necessity or a luxury.

The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-
price elasticity of demand, this measurement is calculated by taking the percentage change in
the quantity demanded of one good and dividing it by the percentage change in the price of the
other good.

Price elasticity of supply measures the responsiveness to the supply of a good or service after
a change in its market price. According to basic economic theory, the supply of a good will
increase when its price rises. Conversely, the supply of a good will decrease when its price
decreases

Factors Affecting Demand Elasticity

There are three main factors that influence a good’s price elasticity of demand:
Availability of Substitutes: In general, the more good substitutes there are, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might
replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic
good because a small increase in price will cause a large decrease in demand as consumers start
buying more tea instead of coffee. However, if the price of caffeine itself were to go up, we
would probably see little change in the consumption of coffee or tea because there may be few
good substitutes for caffeine. Most people, in this case, might not willingly give up their
morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an
inelastic product. While a specific product within an industry can be elastic due to the
availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods
such as diamonds are inelastic because they have few if any substitutes.

Necessity: As we saw above, if something is needed for survival or comfort, people will
continue to pay higher prices for it. For example, people need to get to work or drive for a
umber of reasons. Therefore, even if the price of gas doubles or even triples, people will still
need to fill up their tanks.

Time: The third influential factor is time. If the price of cigarettes goes up to $2 per pack, a
smoker with very few available substitutes will most likely continue buying his or her daily
cigarettes. This means that tobacco is inelastic because the change in price will not have a
significant influence on the quantity demanded. However, if that smoker finds that he or she
cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time,
the price elasticity of cigarettes for that consumer becomes elastic in the long run.

The Importance of Price Elasticity in Business

Understanding whether or not a business's good or service is elastic is integral to the success
of the company. Companies with high elasticity ultimately compete with other businesses on
price and are required to have a high volume of sales transactions to remain solvent. Firms that
are inelastic, on the other hand, have goods and services that are must-haves and enjoy the
luxury of setting higher prices.

Beyond prices, the elasticity of a good or service directly affects the customer retention rates
of a company. Businesses often strive to sell goods or services that have inelastic demand;
doing so means that customers will remain loyal and continue to purchase the good or service
even in the face of a price increase.
PRICE ELASTICITY OF DEMAND

Price elasticity of demand is an economic measure of the change in the quantity demanded or
purchased of a product in relation to its price change. Expressed mathematically, it is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Price elasticity is used by economists to understand how supply or demand changes given
changes in price to understand the workings of the real economy. For instance, some goods are
very inelastic, that is, their prices do not change very much given changes in supply or demand,
for example people need to buy gasoline to get to work or travel around the world, and so if oil
prices rise, people will likely still buy just the same amount of gas. On the other hand, certain
goods are very elastic, their price moves cause substantial changes in its demand or its supply.
(Arc elasticity is the elasticity of one variable with respect to another between two given
points.) Here, we will look just at how the demand side of the equation is impacted by
fluctuations in price by considering the price elasticity of demand – which you can contrast
with price elasticity of supply.

Price Elasticity of Demand Explained

If the quantity demanded of a product exhibits a large change in response to changes in its
price, it is termed "elastic," that is, quantity stretched far from its prior point. If the quantity
purchased has a small change in response to its price, it is termed "inelastic"; or quantity didn't
stretch much from its prior point.

The more easily a shopper can substitute one product with a rising price for another, the more
the price will fall – be "elastic." In other words, in a world where people equally like coffee
and tea, if the price of coffee goes up, people will have no problem switching to tea, and so the
demand for coffee will fall. This is because coffee and tea are considered good substitutes to
each other.

The more discretionary a purchase is, the more its quantity will fall in response to price rises,
that is, the higher the elasticity. So, if you are considering buying a new washing machine but
the current one still works (it's just old and outdated), and if the prices of new washing machines
go up, you're likely to forgo that immediate purchase and wait either until prices go down or
until the current machine breaks down.

On the other hand, the less discretionary a good is, the less its quantity demanded will fall.
Inelastic examples include luxury items where shoppers "pay for the privilege" of buying a
brand name, addictive products, and required add-on products. Addictive products may include
tobacco and alcohol. Sin taxes on these types of products are possible to introduce because the
lost tax revenue from fewer units sold is exceeded by the higher taxes on units still sold.
Examples of add-on products are ink-jet printer cartridges or college textbooks. These items
are usually more necessary (as opposed to discretionary) and lack good substitutes (only HP
ink will work in HP printers).

Time also matters. Demand response to price fluctuations is different for a one-day sale than
for a price change over a season or year. Clarity in time sensitivity is vital to understanding the
price elasticity of demand and for comparing it across different products.

Examples of Price Elasticity of Demand

Generally, as rules of thumb, if the quantity of a good demanded or purchased changes more
than the price change, the product is termed elastic. (The price changes by +5%, but the demand
falls by -10%). If the change in quantity purchased is the same as the price change (say,
10%/10% = 1), the product is said to have unit (or unitary) price elasticity. Finally, if the
quantity purchased changes less than the price (say, -5% demanded for a +10% change in
price), then the product is termed inelastic.

To calculate the elasticity of demand, let's take a very simple example: Suppose that the price
of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers
increase their apple purchases by 20%. The elasticity of apples would thus be: 0.20/0.06 = 3.33
indicating that apples are quite elastic in terms of their demand.
FORECASTING
DEMAND FORECASTING
Demand Forecasting is the process in which historical sales data is used to develop an estimate
of an expected forecast of customer demand. To businesses, Demand Forecasting provides an
estimate of the amount of goods and services that its customers will purchase in the foreseeable
future. Critical business assumptions like turnover, profit margins, cash flow, capital
expenditure, risk assessment and mitigation plans, capacity planning, etc. are dependent on
Demand Forecasting.

Demand Forecasting types

Demand Forecasting can be broadly classified based on the level of detailing, time span
considered and the scope of market considered.

Outlined below are the major types of Demand Forecasting

Passive Demand Forecasting: Passive Demand Forecasting is carried out for stable
businesses with very conservative growth plans. Simple extrapolations of historical data is
carried out with minimal assumptions. This is a rare type of forecasting limited to small and
local businesses.
Active Demand Forecasting: Active Demand Forecasting is carried out for scaling and
diversifying businesses with aggressive growth plans in terms of marketing activities, product
portfolio expansion and consideration of competitor activities and external economic
environment.
Short-term Demand Forecasting: Short-term Demand Forecasting is carried out for a shorter-
term period of 3 months to 12 months. In the short term, the seasonal pattern of demand and
the effect of tactical decisions on the customer demand are taken into consideration.
Medium to long-term Demand Forecasting: Medium to long-term Demand Forecasting is
typically carried out for more than 12 months to 24 months in advance (36-48 months in certain
businesses). Long-term Forecasting drives the business strategy planning, sales and marketing
planning, financial planning, capacity planning, capital expenditure, etc.
External macro level Demand Forecasting: This type of Forecasting deals with the broader
market movements which depend on the macroeconomic environment. External Forecasting is
carried out for evaluating the strategic objectives of a business-like product portfolio
expansion, entering new customer segments, technological disruptions, a paradigm shift in
consumer behavior and risk mitigation strategies.
Internal business level Demand Forecasting: As the name suggests, this type of Forecasting
deals with internal operations of the business such as product category, sales division, financial
division, and manufacturing group. This includes annual sales forecast, estimation of COGS,
net profit margin, cash flow, etc.

Importance of Demand Forecasting

Demand Forecasting is the pivotal business process around which strategic and operational
plans of a company are devised. Based on the Demand Forecast, strategic and long-range plans
of a business-like budgeting, financial planning, sales and marketing plans, capacity planning,
risk assessment and mitigation plans are formulated.

Short to medium term tactical plans like pre-building, make-to-stock, make-to-order, contract
manufacturing, supply planning, network balancing, etc. are execution based. Demand
Forecasting also facilitates important management activities like decision making, performance
evaluation, judicious allocation of resources in a constrained environment and business
expansion planning.

Usefulness of Demand Forecasting

Demand plays a vital role in the decision making of a business. In competitive market
conditions, there is a need to take correct decision and make planning for future events related
to business like a sale, production, etc. The effectiveness of a decision taken by business
managers depends upon the accuracy of the decision taken by them. Demand is the most
important aspect for business for achieving its objectives. Many decisions of business depend
on demand like production, sales, staff requirement, etc. Forecasting is the necessity of business
at an international level as well as domestic level. Demand forecasting reduces risk related to
business activities and helps it to take efficient decisions. For firms having production at the
mass level, the importance of forecasting had increased more. A good forecasting helps a firm
in better planning related to business goals. There is a huge role of forecasting in functional
areas of accounting. Good forecast helps in appropriate production planning, process selection,
capacity planning, facility layout planning, and inventory management, etc. Demand
forecasting provides reasonable data for the organization’s capital investment and expansion
decision. It also provides a way for the formulation of suitable pricing and advertisement
strategies.
Significance of Demand Forecasting:

1. Fulfilling objectives of the business

2. Preparing the budget

3. Taking management decision

4. Evaluating performance etc.

Moreover, forecasting is not completely full of proof and correct. It thus helps in evaluating
various factors which affect demand and enables management staff to know about various
forces relevant to the study of demand behavior.

METHODS OF DEMAND FORECASTING

One of the most important steps of the Demand Forecasting process is the selection of the
appropriate method for Demand Forecasting. Demand can be forecasted using (A) Qualitative
methods or (B) Quantitative methods as explained below:

Qualitative methods:

• The Delphi Technique: A panel of experts are appointed to produce a Demand

Forecast. Each expert is asked to generate a forecast of their assigned specific segment.
After the initial forecasting round, each expert reads out their forecast and in the
process, each expert is influenced by other experts. A consequent forecast is again made
by all experts and the process is repeated until all experts reach a near consensus
scenario.

• Sales Force Opinion: The Sales Manager asks for inputs of expected demand from
each Salesperson in their team. Each Salesperson evaluates their respective region and
product categories and provides their individual customer demand. Eventually, the
Sales Manager aggregates all the demands and generates the final version of Demand
Forecast after management’s judgment.

• Market Research: In market research technique, customer-specific surveys are

deployed to generate potential demand. Such surveys are generally in the form of
questionnaires that directly seeks personal, demographic, preference and economic
information from end customers. Since this type of research is on a random sampling
 basis, care needs to be exercised in terms of the survey regions, locations, and
demographics of the end customer. This type of method could be beneficial for products
that have little to no demand history.

Quantitative methods:

• Trend projection method: Trend projection method can be effectively deployed for
businesses with a large sales data history of typically more than 18 to 24 months. This
historical data generates a “time series” which represents the past sales and projected
demand for a specific product category under normal conditions by a graphical plotting
method or the least square method.

• Barometric technique: Barometric technique of Demand Forecasting is based on the

principle of recording events in the present to predict the future. In the Demand
Forecasting process, this is accomplished by analyzing the statistical and economic
indicators. Generally, forecasters deploy statistical analysis like Leading series,
Concurrent series or Lagging series to generate the Demand Forecast.

• Econometric forecasting technique: Econometric forecasting utilizes autoregressive

integrated moving-average and complex mathematical equations, to establish
relationships between demand and factors that influence the demand. An equation is
derived and fine-tuned to ensure a reliable historical representation. Finally, the
projected values of the influencing variables are inserted into the equation to generate
a forecast.

TYPES OF FORECASTING

There are several different ways to do demand forecasting. Your forecast may differ based on
the forecasting model you use. Best practice is to do multiple demand forecasts. This will give
you a well-rounded picture of your future sales. Using more than one forecasting model can
also highlight differences in predictions. Those differences can point to a need for more
research or better data inputs.

1. Passive demand forecasting

Passive demand forecasting is the simplest type. In this model, you use sales data from the past
to predict the future. You should use data from the same season to project sales in the future,
so you compare apples to apples. This is particularly true if your business has seasonal
fluctuations. The passive forecasting model works well if you have solid sales data to build on.

In addition, this is a good model for businesses that aim for stability rather than growth. It’s an
approach that assumes that this year’s sales will be approximately the same as last year’s sales.
Passive demand forecasting is easier than other types because it doesn’t require you to use
statistical methods or study economic trends.

2. Active demand forecasting

If your business is in a growth phase or if you’re just starting out, active demand forecasting is
a good choice. An active forecasting model takes into consideration your market research,
marketing campaigns, and expansion plans. Active projections will often factor in externals.
Considerations can include the economic outlook, growth projections for your market sector,
and projected cost savings from supply chain efficiencies. Startups that have less historical data
to draw on will need to base their assumptions on external data.

3. Short-term projections

Short-term demand forecasting looks just at the next three to 12 months. This is useful for
managing your just-in-time supply chain. Looking at short-term demand allows you to adjust
your projections based on real-time sales data. It helps you respond quickly to changes in
customer demand. If you run a product lineup that changes frequently, understanding short-
term demand is important. For most businesses, however, a short-term forecast is just one piece
of a larger puzzle. You’ll probably want to look further out with medium- or long-term demand
forecasting.

4. Long-term projections

Your long-term forecast will make projections one to four years into the future. This forecasting
model focuses on shaping your business growth trajectory. While your long-term planning will
be based partly on sales data and market research, it is also aspirational. Think of a long-term
demand forecast as a roadmap. Using this forecasting technique, you can plan out your
marketing, capital investments, and supply chain operations. That will help you to prepare for
future demand. Being ready for your business growth is crucial to making that growth happen.
 5. External macro forecasting

External macro forecasting incorporates trends in the broader economy. This projection looks
at how those trends will affect your goals. An external macro demand forecast can also give
you direction for how to meet those goals. Your company may be more invested in stability
than expansion. However, a consideration of external market forces is still essential to your
sales projections. External macro forecasts can also touch on the availability of raw materials
and other factors that will directly affect your supply chain.

6. Internal business forecasting

One of the limiting factors for your business growth is internal capacity. If you project that
customer demand will double, does your enterprise have the capacity to meet that demand?
Internal business demand forecasts review your operations. The internal business forecasting
type will uncover limitations that might slow your growth. It can also highlight untapped areas
of opportunity within the organization. This forecasting model factors in your business
financing, cash on hand, profit margins, supply chain operations, and personnel. Internal
business demand forecasting is a helpful tool for making realistic projections. It can also point
you toward areas where you need to build capacity in order to meet expansion goals.

DEMAND FORECASTING METHODS IN DETAIL:

There are many different ways to create forecasts. Here are five of the top demand forecasting
methods.

Trend projection

Trend projection uses your past sales data to project your future sales. It is the simplest and
most straightforward demand forecasting method. It’s important to adjust future projections to
account for historical anomalies. For example, perhaps you had a sudden spike in demand last
year. However, it happened after your product was featured on a popular television show, so it
is unlikely to repeat. Or your ecommerce site got hacked, causing your sales to plunge. Be sure
to note unusual factors in your historical data when you use the trend projection method.

Market research
Market research demand forecasting is based on data from customer surveys. It requires time
and effort to send out surveys and tabulate data, but it’s worth it. This method can provide
valuable insights you can’t get from internal sales data.

You can do this research on an ongoing basis or during an intensive research period. Market
research can give you a better picture of your typical customer. Your surveys can collect
demographic data that will help you target future marketing efforts. Market research is
particularly helpful for young companies that are just getting to know their customers.

Sales force composite

The sales force composite demand forecasting method puts your sales team in the driver’s seat.
It uses feedback from the sales group to forecast customer demand. Your salespeople have the
closest contact with your customers. They hear feedback and take requests. As a result, they
are a great source of data on customer desires, product trends, and what your competitors are
doing. This method gathers the sales division with your managers and executives. The group
meets to develop the forecast as a team.

Delphi method

The Delphi method, or Delphi technique, leverages expert opinions on your market forecast.
This method requires engaging outside experts and a skilled facilitator. You start by sending a
questionnaire to a group of demand forecasting experts. You create a summary of the responses
from the first round and share it with your panel. This process is repeated through successive
rounds. The answers from each round, shared anonymously, influence the next set of responses.
The Delphi method is complete when the group comes to a consensus.

This demand forecasting method allows you to draw on the knowledge of people with different
areas of expertise. The fact that the responses are anonymously allows each person to provide
frank answers. Because there is no in-person discussion, you can include experts from
anywhere in the world on your panel. The process is designed to allow the group to build on
each other’s knowledge and opinions. The end result is an informed consensus.

Econometric

The econometric method requires some number crunching. This technique combines sales data
with information on outside forces that affect demand. Then you create a mathematical formula
to predict future customer demand. The econometric demand forecasting method accounts for
relationships between economic factors. For example, an increase in personal debt levels might
coincide with an increased demand for home repair services.

Demand Forecasting objectives

Objectives of Demand Forecasting include Financial planning, Pricing policy, Manufacturing

policy, Sales, and Marketing planning, Capacity planning and expansion, Manpower planning
and Capital expenditure.

Demand Forecasting models

Based on the specific requirements of a business or a product category, a customized Demand

Forecasting model can be developed. Such a model is an extension or combination of various
Qualitative and Quantitative Methods of Demand Forecasting. The task of developing a
customized model is often iterative, highly detailed and expertise-driven and can be
accomplished by implementing a suitable demand management software.

Types of Forecasting

1. Based on Economy

There are three types of forecasting based on the economy:

Macro-level forecasting: It deals with the general economic environment relating to the
economy as measured by the Index of Industrial Production(IIP), national income and general
level of employment, etc.

Industry level forecasting: Industry level forecasting deals with the demand for the industry’s
products as a whole. For example demand for cement in India, demand for clothes in India, etc.

Firm-level forecasting: It means forecasting the demand for a particular firm’s product. For
example, demand for Birla cement, demand for Raymond clothes, etc.

2. Based on the Time Period

Forecasting based on time may be short-term forecasting and long-term forecasting

Short-term forecasting: It covers a short period of time, depending upon the nature of the
industry. It is done generally for six months or less than one year. Short-term forecasting is
generally useful in tactical decisions.
Long-term forecasting casting: Long-term forecasts are for a longer period of time say, two to
five years or more. It gives information for major strategic decisions of the firm. For example,
expansion of plant capacity, opening a new unit of business, etc.

ESSENTIALS OF A GOOD FORECASTING

A forecast is said to be successful when the excepted demand is equal to the actual demand.
This can only be possible if the right method of demand forecasting is selected. The criteria
that need to be considered before forecasting the demand for a product are as follows: Accuracy
Implies that an organization should make forecasts close to real figures, so that the real picture
of demand can be determined. For example, there would be an increase in sales in the coming
years is an inaccurate forecast. On the other hand, there would be an increase in sales by 30%
in the next year is an accurate forecast.

Durability:

Implies that forecasts should be done in such a way that they can be used for long periods as
forecasts involves a lot of time, money, and efforts.

Flexibility:

Implies that the forecasts should be adjustable and adaptable to changes. In today’s uncertain
business environment, there is a rapid change in the tastes and preferences of consumers, which
affect the demand for products. Therefore, the demand forecasts made by an organization
should reflect those changes. Apart from this, an organization, while making forecasts, should
consider various business risks that may take place in the future.

Acceptability:

Refers to one of the most important criterion of demand forecasting. An organization should
forecast its demand by using simple and easy methods. In addition, the methods should be such
that organizations do not face any complexities. However, organizations generally prefer
advanced statistical methods, which may prove difficult and complex.

Availability:
Implies that adequate and up-to-date data should be available for forecasts. The forecasts
should be done in timely manner so that necessary arrangements should be made related to the
market demand.

Plausibility:

Implies that the demand forecasts should be reasonable, so that they are easily understood by
individuals who are using it.

Economy:

Implies demand forecasting should be economically effective. The forecasting should be done
in such a manner that the costs should be minimized and benefits should be maximized.

MODULE 3
PRODUCTION FUNCTION

By production function we mean the technological equation that is used to show the
relationship between the physical outputs of a production and physical inputs of a production.
In production function firms present the maximum amount of production output that can be
obtained by the given number of inputs, whether capital or labor.

Production function can be differentiated between the short and the long run production. The
short run production is the period of time during which at least some factors of production are
fixed. The long run is the period of time during which all factors are variable.

The production function is expressed using the following equation:

Q=f(K,L), that is, the quantity of an output (Q), is equal to the function (f) of the amount of
capital (K) plus the amount of labor (L) used in a production. A firm can produce one unit of
output for every unit of capital or labor it employs. From this production function, we can see
that this industry has constant returns to scale, meaning, the amount of output will increase
proportionally to any increase in the amount of inputs.

CLASSIFICATION OF PRODUCTION FUNCTION

Fixed Input or Factors: is a resource or factor of production that the firm cannot change in the
short run as it seeks to change the quantity of output that is produced.

Variable Input or Factors: these are the inputs that a firm can increase or decrease in a short
run depending on the change of outputs that are produced. This means that when an output
increases, the input can be increased, and when the output decreases also the firm can choose
to decrease the output, and this can be done within a short period of time.

ASSUMPTIONS OF PRODUCTION FUNCTION

1. Perfect divisibility of both inputs and outputs

2. Limited substitution of one factor for the others

3. Constant technology

4. Inelastic supply of fixed factors in the short run

LAW OF PRODUCTION

Law of production deals with the concepts of cost and producers equilibrium. It is an important
aspect of economics as it helps a business determine the level of output that leads to maximum
profits.

1. Law of variable proportions: deals with the concept of increasing productivity using
change in production units within limits of existing fixed cost. Law of variable
proportions is written as follows, ”In a given state of technology, when the units of
variable factor of production are increased within the units of other fixed factor, the
marginal productivity increases at increasing rate up to a certain point than after this it
will decrease.”

This law is based on the following assumptions

• The technique of production remains the same

• This law is adopted for short run only

• Labor and raw materials are variable factors

 • All factors are not kept rigidly fixed proportions but the law is based upon the
possibilities of varying proportions such as electricity consumption. So this law is
also called the law of proportionality.

• Units produced during production are homogeneous in amount and quantity.

2. Law of Returns to Scale: it has three types of laws that falls under t

• Law of increasing returns: applies when the units of a variable factors are increased
with the units of fixed factors and the marginal productivity increases.

• Law of constant returns: it is when the units of variable factors are increased with
the units of other fixed factors, and the marginal productivity remains constant.

• Law of diminishing returns: this law is applicable when the units of variable factors
of production are increased with the units of other fixed factor, and the marginal
productivity decreases.

ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale is the cost advantage that a firm experiences when it increases its level of
output. The advantage arises due to the inverse relationship between per-unit fixed cost and the
quantity produced. The greater the quantity of output produced, the lower the per-unit fixed
cost. Economies of scale also result in a fall in average variable costs with an increase in output.
It can be implemented by a firm at any stage of production.

Types of economies of scale

• Internal economies of scale: it refers to the economies that are unique to a firm.

• External economies of scale: it refers to the economies that are enjoyed by an entire
industry.

Diseconomies of scale: it happens when a company grows so large that the cost per unit
increases, it takes place when the economies of scale no longer function for a firm. With this
principle, rather than experiencing continued decreasing costs and increasing output, a firm
sees an increase in costs when the output is increased.
COST OUTPUT RELATIONSHIP

In the long run, the costs fall as output increases due to economies of scale, consequently the
average costs of production falls. All factors are variable and the average cost may fall or
increase respectively, but all the costs are above the long run average cost.

In the short run, the greater the output, the lesser the fixed cost per unit, that is the average
fixed cost. Total fixed cost remain the same and do not change with a change in output. The
average variable cost will first and then rise as more and more units are produced in a given
place.

THE CONCEPT OF BREAK EVEN ANALYSIS

Break-even analysis is a technique that is used by management for calculating and examining
the margin of safety for an entity based on the revenues collected and associated costs. It deals
with categorizing the costs of manufacturing of the fixed and variable products, the analysis
shows how many sales it takes to pay for the cost of doing business. Break-even analysis looks
at the level of fixed costs relative to the profit earned by each additional unit produced and
sold. In general, a company with lower fixed costs will have a lower break-even point of sale.

Analyzing different price levels relating to various levels of demand, the break-even analysis
determines what level of sales are necessary to cover the company's total fixed costs. A
demand-side analysis would give a seller significant insight into selling capabilities. Break-
even analysis determines the level of production or a targeted desired sales mix, it involves a
calculation of the break-even point (BEP). The break-even point is calculated by dividing the
total fixed costs of production by the price per individual unit less the variable costs of
production. Fixed costs are costs that remain the same regardless of how many units are sold.

Elements of Break Even Analysis

1. Fixed costs: These are the costs that stay the same no matter how much the business
sells, also referred to as overhead costs. They include utilities, bills, salaries and wages,
rent, and insurance.

2. Variable costs: Variable costs are based on a business's sales. They can include
additional labor from independent contractors, materials and payment processing fees.
 3. Average price: This is the average amount you will charge for your products and
services.

AN ILLUSTRATION FOR SPECIFYING BREAK EVEN CALCULATIONS

Formula for Break Even Analysis

• Break even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)

Where:

• Fixed costs are costs that do not change with varying output (e.g., salary, rent, building
machinery).

• Sales price per unit is the selling price (unit selling price) per unit.

• Variable cost per unit is the variable costs incurred to create a unit.

It is also helpful to note that sales price per unit minus variable cost per unit is the contribution
margin per unit. For example, if a book’s selling price is $100 and its variable costs are $5 to
make the book, $95 is the contribution margin per unit and contributes to offsetting the fixed
costs.

Example of Break Even Analysis

Colin is the managerial accountant in charge of Company A, which sells water bottles. He
previously determined that the fixed costs of Company A consist of property taxes, a lease, and
executive salaries, which add up to $100,000. The variable cost associated with producing one
water bottle is $2 per unit. The water bottle is sold at a premium price of $12. To determine the
break-even point of Company A’s premium water bottle:

Break even quantity = $100,000 / ($12 – $2) = 10,000

Therefore, given the fixed costs, variable costs, and selling price of the water bottles, Company
A would need to sell 10,000 units of water bottles to break even.

Graphically Representing the Break Even Point

The graphical representation of unit sales and dollar sales needed to break even is referred to
as the break even chart or Cost Volume Profit (CVP) graph. Below is the CVP graph of the
example above:
Explanation:

The number of units is on the X-axis (horizontal) and the dollar amount is on the Y-axis
(vertical).

The red line represents the total fixed costs of $100,000.

The blue line represents revenue per unit sold. For example, selling 10,000 units would
generate 10,000 x $12 = $120,000 in revenue.

The yellow line represents total costs (fixed and variable costs). For example, if the company
sells 0 units, then the company would incur $0 in variable costs but $100,000 in fixed costs for
total costs of $100,000. If the company sells 10,000 units, the company would incur 10,000 x
$2 = $20,000 in variable costs and $100,000 in fixed costs for total costs of $120,000. The
break-even point is at 10,000 units. At this point, revenue would be 10,000 x $12 = $120,000
and costs would be 10,000 x 2 = $20,000 in variable costs and $100,000 in fixed costs.

When the number of units exceeds 10,000, the company would be making a profit on the units
sold. Note that the blue revenue line is greater than the yellow total costs line after 10,000 units
are produced. Likewise, if the number of units is below 10,000, the company would be
incurring a loss. From 0-9,999 units, the total costs line is above the revenue line.

APPLICATION OF A BREAK EVEN ANALYSIS

Break even analysis not only highlights the areas of economic strength and weakness in the
firm, but also helps in finding out the ways which can enhance its profitability. With the help
of this analysis management of production firm can take decisions related to the following:
 1. Safety margin. It decides the extent to which the firm can afford to decline in sales,
before it starts incurring losses.

2. Volume needed to attain target profit.

3. Change in price, and its affect.

4. Whether to expand production capacity or not.

5. Whether to add a new product or drop production of any product.

6. Whether to make or buy.

7. Selection of production machinery so as to get maximum profit for a particular volume

of the product out of the available machineries.

8. Improving profit performance by:

• Increasing the volume of sales, and or

• Increasing the selling prices, and or

• Reducing the variable expenses per unit, and or

• Reducing the fixed costs.

There are many situations in running a business where a break-even analysis comes in handy.
According to Rick Vazza, a CFA and CFP and the president of Driven Wealth Management,
break-even analysis should be used to answer the following questions about your business:

1. How much of my product or service do I need to sell per month?

2. How much volume do I expect to sell?

3. What price makes those figures match my break-even calculation?

4. What price allows me to generate a reasonable profit?

The goal is to get an accurate look at what your profit, net cash flow and finances will be. "It's
much easier for people to decide whether they can beat that minimum than guessing how many
sales they may make," said Rob Stephens, founder of CFO Perspective.

Here are three times when a break-even analysis should be performed

1. If you are expanding your business:

Stephens suggests using a break-even analysis to get a reality check on how long it will take
any planned investments or changes in your business to become profitable. "These investments
might be a new product or location," Stephens said. "I've done break-even calculations many
times for modeling the minimum sales needed to cover the costs of a new location."

2. If you need to lower the pricing:

This analysis is also helpful when you need to lower your prices to beat a competitor. "You can
also use break-even analysis to determine how many more units you need to sell to offset a
price decrease," Stephens said. "The most common use of break-even analysis in my career has
been modeling price changes."

3. If you want to narrow down the options:

When making changes to your business, you may be bombarded with various scenarios and
possibilities, which can be overwhelming when you're trying to make a decision. Stephens
suggests using a break-even analysis to reduce your decisions to scenarios with straightforward
yes-or-no questions like, "Can we do better than the minimum needed for success?"

MODULE 4
DETERMINATION

Determination of prices means to determine the cost of goods sold and services rendered in the
free market. In the free market, the forces of supply and demand determine the prices.
The government does not interfere in the determination of the prices. However, in some cases
the government may intervene in determining the prices. Consumers have a desire to acquire a
product, and producers manufacture a supply to meet this demand. The equilibrium market
price of a good is the price at which quantity supplied is equal to quantity demanded.

Profit Maximization Under Perfect Competition

The primary objective of any business is to maximize the profit. Profit can be increased either
by increasing total revenue (TR) or by reducing the total cost (TC). The profit is nothing but
the difference between the revenue and the cost.

The total profit = TR – TC

Let us assume that whatever produced is sold in the market.

TR = Quantity sold x price

To increase the revenue, it is better to either increase the quantity sold or increase the price.
Therefore, while increasing the revenue or minimizing the total cost of production over a period
of time with attendant economies of scale will widen the difference to gain more profit.

In perfect market, the firm’s Marginal cost, Average cost, Average revenue, Marginal revenue
are equal to the price of the commodity. The cost is measured as average cost and marginal
cost. When the firm is in equilibrium, producing the maximum output i.e., cost of the last item
produced is known as marginal cost. The total cost divided by the number of goods produced
will give the average cost. When the firm is operating in perfect market MC = AC.

In the same way the revenue available to the firm through selling goods is called as total
revenue. The last item sold is the marginal revenue. The total revenue divided by the number
of items sold is the average revenue and when the firm is working in the perfect market the MR
shall be equal to AR. Therefore, the MC = MR = AR = AC = P in the short run. The size of the
plant is fixed only with the variable factors and the price is fixed by the demand and supply.

Perfect Market Price Determination

The price of the commodity includes the normal profit through the average cost. The average
cost consists of implicit and explicit costs. That means the organizers knowledge, time, idea
and effort is also considered in the cost of production. Let us assume that in the short run the
demand for the commodity increases.
Short Run Profit Maximization Under Perfect Competition

The profit = Total Revenue (TR) – Total Cost (TC)

TR = quantity sold x price

TC = average cost x quantity produced

TR = OM

1 x OP1 = OM1Q1P1

TC = M

1R x OM1 = OM1RS

Profit = OM

1Q1P1 - OM1RS = P1Q1RS93

Even in the perfect market it is possible to earn profit in the short period. It indicates clearly
that in the short run, in any perfect market, the increase in demand will increase the profit to
the businessmen. The normal profit will be there until it gets equalized with the demand.

This economic profit attracts new firms into the industry and the entry of these new firms
increases the industry supply. This increased supply pushes down the price. As price falls, all
firms in the industry adjust their output levels in order to remain in profit maximizing
equilibrium.

New firms continue to enter the industry and price continues to fall, and existing firms continue
to adjust their outputs until all economic profits are eliminated. There is no longer an incentive
for the new firms to enter and the owners of all firms in the industry will earn only what they
could make through their best alternatives.

Economic losses motivate some to exit (shut down) from the industry. The exit of these firms
decreases industry supply. The reduction in supply pushes up market price and all the firms
shall adjust their output in order to maximize their profit.

Shut Down Point:

If the market price for the product is below minimum average variable cost, the firm will cease
to produce, if this appears to be not just a temporary phenomenon. When the price is less than
average variable cost it will neither cover fixed cost nor a part of the variable costs. Then the
firm can minimize losses up to total fixed costs only by not producing. It is therefore regarded
as the shut down point.

In the short run, a firm can be in equilibrium at various levels depending upon different cost
and market price conditions. But these are temporary equilibrium points. Thus at this unstable
equilibrium point the firm gets excess profits or normal profit and sometimes incur loss also.

Consequences of Pure Competition

Perfect competition ensures maximum welfare of the people as a whole. Each firm tends to
attain the most efficient size to expand output and to reduce the average cost of production.

Lessons for Managers

1. Important to enter a growing market as far ahead of the competitors as possible. When there
is fall in supply and increase in prices, take advantage before the new entrants.

2. Due to profit new entrants are willing to offer, low priced therefore a firm should be among
the lowest cost producer to ensure its survival.

3. Differentiation offers temporary relief for competition pressure.

4. Due to globalization firms enjoy advantage of cheap labour and disadvantage of technology
up gradation.

Monopoly Market
Mono means single, poly means seller and hence monopoly is a market structure where only
one sells the goods and many buyers buy the same. Monopoly lies at the opposite extreme from
perfect competition on the market structure continuum. A firm produces the entire supply of a
particular good or service that has no close substitute.

Characteristic Features:

1. A single seller in the market

2. There are no close substitutes

3. There is a restriction for the entry and exit for the firms in the market

4. Imperfect dissemination of information

This does not mean that the monopoly firms are large in size. For example a doctor who has a
clinic in a village has no other competitor in the village but in the town there may be more
doctors. Therefore the barrier to the entry is due to economies of scale, economies of scope,
cost complementarities, patents and other legal barriers.

Profit maximization under Monopoly Competition

For monopolist there are two options for maximizing the profit i.e. maximize the output and
the limit the price or limit the production of the goods and services and fix a higher price
(market driven price). In monopoly competition, the demand curve of the firm is identical to
the market demand curve of that product. In monopoly the MR is always less than the price of
the commodity.

Difference Between Perfect and Monopoly Market:

1. Perfect market is unrealistic in practical life. But slowly certain commodities are moving
towards it. Monopoly market exists in real time.

2. Under perfect market only homogenous products are sold but on the other hand monopoly
market deals with different products.

3. Under perfect competition, price is determined by demand and supply of the market. But in
monopoly the seller determines the price of the good.

4. Monopolist can control the market price but in perfect competition the sellers have no control
over the market price.

5. There is no advertisement cost in perfect market. In other markets it is essential and it is

included in the cost of production and is reflected in the price.

6. Monopolist sell their products higher than the perfect competitors except when there is
government regulation or adverse public opinion.

Lessons For Managers:

1. The seller has to fix the price based on the marginal revenue and marginal cost instead of
focusing on their profit.

2. It is essential to understand the substitutes and their market competition.

3. Under monopoly for certain products buyer has more market power.
4. Government policies can also change at any time.

5. Monopolist in domestic market may face tough competition from imported products.

Monopolistic Competition
The perfect competition and monopoly are the two extreme forms.

To bridge the gap the concept of monopolistic competition was developed by Edward
Chamberlin. It has both the elements like many small sellers and many small buyers. There is
product differentiation. Therefore, close substitutes are available and at the same time it is easy
to enter and easy to exit from the market. Therefore, it is possible to incur loss in this market.

The profit maximization for each firm, for each product depends upon the differentiation and
advertising expenditure. As every firm is acting as a monopoly the same logic of monopoly is
followed. Each and every firm will have their own set of cost and revenue curves and the price
determination is based on the rule of MR=MC and they incur varied profits according to their
market structure. But in the monopolistic competition number of monopoly competitors will
be there in different levels. They monopolize in a small geographical area or a segment or a
model.

The demand curve of a monopolistically competitive firm would be more elastic than that of a
purely monopolistic firm. The cost function of a firm would be that there will not be any
significant difference across different types of structures in the product market. Given the
function, and the corresponding AR and MR curves, and the cost function, and the
corresponding SAC and SMC curves, the price and output determination of a profit –
maximizing monopolistically competitive firm could be as follows

Oligopoly Market

This is a market consisting of a few firms relatively large firms, each with a substantial share
of the market and all recognizing their interdependence. It is a common form of market
structure. The products may be identical or differentiated. The price determination and profit
maximization is based on how the competitors will respond to price or output changes.

There Are Different Types of Oligopoly:

1.Pure and perfect oligopoly: if the firm produced homogeneous products it is perfect
oligopoly. If there is product differentiation then it is called as imperfect or differentiated
oligopoly.

2.Open and closed oligopoly: entry is not possible. When it is closed to the new entrants then
it is closed oligopoly. On the other hand entry is accepted in open oligopoly.

3.Partial and full oligopoly: under partial oligopoly industry is dominated by one large firm
who is a price leader and others follow. In full oligopoly no price leadership.

4.Syndicated and organized oligopoly: where the firms sell their products through a
centralized syndicate. On the other hand firms organize themselves into a central association
for fixing prices, output and quotas.

Characteristic Features of An Oligopoly Market:

1. Few sellers

2. Lack of uniformity in the product

3. Advertisement cost is included

4. No monopoly competition

5. Firms struggle constantly

6. There is interdependency

7. Experience of Group behavior

8. Price rigidity

9. Price leadership

10. Barriers to entry

Price rigidity: the price will be kept unchanged due to fear of retaliation and prices tend to be
strict and inflexible. No firm would indulge in price cutting as it would eventually lead to a
price war with no benefit to anyone.
Reasons for rigidity are: firms know ultimate outcome of price cutting; large firms incur more
expenditure than others; keeping the price low to reduce the new entrants; increased price rise
leads to reduction in number of customers.

The oligopoly prices are indeterminate. The demand function is then an important ingredient
in the price determination mechanism. Several theories of oligopoly prices have been
developed and each one of them is based on a particular assumption about the reactions of the
rival firms and the firms’ actions. The popular models and appropriate classifications are
discussed below.

Oligopoly Models:
1.Cournot oligopoly: There are few firms producing differentiated or homogeneous products
and each firm believes that competitors will hold their output constant if it changes its output.

2.Stackelberg oligopoly: Few firms and differentiated or homogeneous product. The leader
chooses an output and others follow.

3.Bertrand oligopoly: Few firms produce identical product. Firms compete in price and react
optimally to competitor’s prices.

4.Sweezy oligopoly: An industry in which there are few firms serving many consumers. Firms
produce differentiated products and each firm believes competitors will respond to a price
reduction but they will not follow a price increase.

MODULE 5
MACRO ECONOMIC PROBLEMS

Macroeconomics is the study of aggregate economic behaviour of the economy as a whole.

Macroeconomics deals with the output, (total volume of goods and services produced) levels
of employment and unemployment, average prices of goods and services. It also deals with the
economic growth of the country, trade relationship with other countries and the exchange
values of the currency in the international market.

The major factors influencing these outcomes are international market forces like population
growth, consumption behaviour of the country, external forces like, natural calamities, political
instability and policy related changes such as tax policy, government expenditure (budget)
money supply and various other economic policies of the country. Therefore it is essential to
know the aggregate demand and aggregate supply of the country.

Aggregate demand: The total quantity of output demanded at prevailing price levels in a given
time period, ceteris paribus.

Aggregate supply: The total quantity of the output the producers are willing and able to supply
at prevailing price levels in a given time period. These two summarizes the market activity of
the economy. But the economy is disturbed by unemployment, inflation and business cycles.

Various economic policies like Fiscal policy and monetary policy are followed by the
government to achieve the equilibrium between aggregate demand and aggregate supply.

The following chapters will help us to understand the Macro Economic concepts, their
behaviour and its impact on the economy. Thus, an understanding of macroeconomics and
policies is of utmost importance to managers. Managers have to cope with the economic
environment at two levels - firm level and macro level.

Objectives Of Economic Policies:

The major macro level economic policies framed by the government of India to achieve the
objectives are:

1. To achieve national level full employment

2. To stabilize the price fluctuations in the market

3. To achieve overall economic growth

4. To develop regions economically

5. To improve the standard of living of the people

6. To reduce income inequalities

7. To control monopoly market structure

8. To avoid cyclical fluctuations in various economic activities of the country

9. To improve the Balance of Payment of the country and

10. To bring social justice in various aspects.

11. Now let us understand the various macroeconomic concepts.

National Income

The purpose of national income accounting is to obtain some measure of the performance of
the aggregate economy. The major concepts used in the national income calculation are Gross
Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP),
personal income and Disposable income. Gross Domestic Product is the total market value of
all final goods and services currently produced within the domestic territory of a country in a
year. It measures the market value of annual output of goods and services currently produced
and counted only once to avoid double counting. It includes only final goods and services. It
includes the value of goods and services produced within the domestic territory of a country
by nationals and non-nationals. Gross National Product is the market value of all final goods
and services produced in a year. GNP includes net factor income from abroad. GNP = GDP +
Net factor income from abroad (income received by Indian’s abroad – income paid to foreign
nationals working in India). Net National Product at market price is the market value of all
final goods and services after providing for depreciation.

NNP = GNP – Depreciation

Depreciation means fall in the value of fixed capital due to wear and tear.

NNP at factor cost is called as National Income:

National income is the sum of the wages, rent, interest and profits paid to factors for their
contribution to the production of goods and services in a year.

Nnp = Nnp (Market Price) – Indirect Tax + Subsidies

Personal income (PI) is the sum of all incomes earned by all individuals / households during a
given year. Certain incomes are received but not earned such as old age pension etc.,

Pi = Ni – Social Security Contribution – Corporate Income Tax – Undistributed Corporate

Profits + Transfer Payments.
Disposable income is calculated by deducting the personal taxes like income tax, personal
property tax from the personal income (PI).

Disposable Income = Personal Income – Personal Taxes = Consumption + Saving

Supernumerary income: the expenditure to meet necessary living costs deducted from
disposable consumer income is called as supernumerary income. The economy is divided into
different sectors such as agriculture, fisheries, mining, construction, manufacturing, trade,
transport, communication and other services. The gross production is found out by adding up
the net values of all the production that has taken place in these sectors during a given year.
This method helps to understand the importance of various sectors of the economy.

Approaches to Calculate National Income:

The Income Approach:

The income of individuals from employment and business, the profits of the firms and public
sector earnings are taken into consideration.

National Income is the income of individuals + self-employment + profits of firms and public
corporate bodies + rent + interest (transfer payments, scholarships, pensions are not included)
this includes the sum of the income earned by individuals from various input factors such as
rent of land, wages and salaries of employees, interest on capital, profits of entrepreneurs and
income of self employed people. This method indicates the income distribution among various
income groups of people.

The Expenditure Approach:

In this approach national income is calculated by using the expenditure of individuals, private,
government and foreign sectors. i.e., the sum of all the expenditure made on goods and services
during a year. i.e., National Income = Expenditure Of Individuals + Govt. + Private Firms +
Foreigners

GDP = C + I + G + (X-M) Where,

C = expenditure on consumer goods and services by individuals and households

I = expenditure by private business enterprises on capital goods

G = government expenditure on goods and services (government purchase)

X-M = exports - imports

The Output Approach:

In this approach we measure the value of output produced by firms and other organization in a
particular time period. i.e., the National Income = income from agriculture + fishery + forestry
+ construction + transportation + manufacturing + tourism + water + energy …

Gdp At Market Price + Subsidies –Taxes

Gnp At Factor Cost + Net Income from Abroad

Factors Determining National Income:

1. Quantity of goods and services produced by the country. Higher the quantity of production,
higher shall be the national income.

2. Quality of products and services produced in the country will also determine the national
income of a country.

3. Innovation of more technical skills will improve the productivity which will reflect on
national income of the country.

4. Political stability strengthens the national income of an economy. Difficulties In The

Calculation Of National Income:

• Any income earned abroad have to be included

• To avoid double counting, value added method should be considered

• Services rendered free of charges are not to be included

• Capital gains, transfer payments are not to be included

• Changes in price level will also affect the calculation

• Value of military services will not be taken into consideration.

Problems in Measuring National Income in India:

1. Non monetized sector: there are number of sectors in which the wages and salaries are
provided in kind, not in monetary measures.

2. Illiteracy: due to higher illiteracy rate the results may be biased.119

3. Lack of occupational specification: we have difficulty in classifying the nature of the job
existing in India.

4. Unorganized productive activities: people involved in unorganized productive activities are

not fully covered in the calculation of national income.

5. Lack of adequate statistical data: Inadequate data leads to approximation of the calculation.

6. Self-consumption: Farm products kept for self-consumption are not considered for the
national income calculation.

7. Unpaid Services: services of house wives are not reckoned as national income.

Uses of National Income Estimates:

1. National income is a measure of economic growth

2. National income is an indicator of success or failure of planning

3. Useful in estimating per capita income

4. Useful in assessing the performance of different production sectors

5. Useful in measuring inequalities in the distribution of income

6. Useful in measuring standard of living

7. Useful in revealing the consumption behaviour of the society

8. Useful in measuring the level and pattern of investment

9. Makes international comparisons possible

Difficulties of Comparing National Income:

It is difficult to compare the national income of a country with others due to the difference in
population size, working hours of labour force, currency values in the market, consumption
pattern of general public, cultural difference and inflationary pressure of the country. Even with
all the above mentioned difficulties the GDP is the major economic indicator of an economy.

National Income and Managers:

The managers of various organizations in different sectors follow the national income statistics
to take managerial decisions at the firm level. Particularly national income data is useful for
the marketing managers, financial managers, production managers, and advertising agents of
any firm. The macro level policy makers will also use the data for their decision making. The
following chapter provides the details regarding the major economic indicators of India.

Economic Indicators

The Indian economy is estimated to grow at 6.9 per cent in 2011-12, after having grown at the
rate of 8.4 per cent in each of the two preceding years. This indicates a slowdown when
compared to the previous two years but even during the period 2003 to 2011. Inflation as
measured by the wholesale price index (WPI) was higher during most of the current fiscal year,
though by the year end there was a clear slowdown. Food inflation, in particular, has come
down to around zero, with most of the remaining WPI inflation being driven by non-food
manufacturing products.

MONETARY TOOLS

Monetary policy was tightened by the Reserve Bank of India (RBI) during the year to control
inflation and curb inflationary pressures. The slowing inflation reflects the lagged impact of
actions taken by the RBI and the government. Reflecting the weak manufacturing activity and
rising costs, revenues of the centre have remained less than anticipated; and, with higher than
budgeted expenditure, a slippage is expected on the fiscal side. The global economic
environment, which has been tenuous at best throughout the year, turned adversely in
September 2011 owing to the turmoil in the Euro zone, and questions about the outlook on the
US economy provoked by rating agencies. However, for the Indian economy, the outlook for
growth and price stability at this juncture looks more promising. There are signs from some
high frequency indicators that the weakness in economic activity has slowed down and a
gradual upswing is imminent.

Trend in Sectoral Composition of GDP

The sectoral contribution of GDP shows that in the 1950s agricultural sector’s contribution was
around 53% but now it has come down to 14%. After opening up our economy the service
sectors contribution has grown tremendously and it has reached 60%. Industrial growth of our
country is very slow with an increase from 16% in 1950 to 27% in 2012.123

Share of World GDP

Indian economy is growing and it is expressed in the various economic activities of our country.
The major economic indicators are growing at a faster rate. The service sector’s contribution
towards the economic development of our country is very high, due to this change the
employment opportunities created by this sector has also grown at a faster rate.

Unemployment:
When people are not working and are actively looking for work or waiting to return to work,
such a situation may be called as unemployment.

Types of Unemployment

1. Frictional unemployment: unemployment that occurs naturally during the normal working
of an economy. Temporarily caused by inefficient movement of people between regions and
jobs, as it takes time for new workers to search and decide for a job. voluntary switching of
jobs, fired or seeking re employment.

2. Structural unemployment: The change in industrial structure of a country, change in

Demand and technology, change in requirement of skills. Mismatch between demand and
supply.

3. Cyclical unemployment: unemployment is more at a particular time that is due to economic

recession, depression and others.

4. Technological unemployment: due to change in technology, new production and process

leads to reduction in work requirement.

5. Seasonal unemployment: in some industries the work cannot be there through out the years
as it is seasonal in nature.

6. Disguised unemployment: lack of work of the type which would fully utilize the degree of
skill possessed by the workers.

Various categories like, ‘workers’, ‘unemployed’, ‘labour force’, ‘out of labour force’ are as
explained below:

• Workers (or employed): Persons who are engaged in any economic activity or who,
despite their attachment to economic activity, have abstained from work for reasons of
illness, injury or other physical disability, bad weather, festivals, social or religious
functions or other contingencies necessitating temporary absence from work constitute
workers. Unpaid helpers who assist in the operation of an economic activity in the
household, farm or non-farm activities are also considered as workers. All the workers
 are assigned one of the detailed activity statuses under the broad activity category
'working or being engaged in economic activity'.

• Seeking or available for work (or unemployed): Persons, who, owing to lack of work,
had not worked but either sought work through employment exchanges, intermediaries,
friends or relatives or by making applications to prospective employers or expressed
their willingness or availability for work under the prevailing condition of work and
remuneration are considered as those who are ‘seeking or available for work’ (or
unemployed).

• Labour force: Persons who are either 'working' (or employed) 'seeking or available for
work' (or unemployed) during the reference period together constitute the labor force.

• Out of labour force: Persons who are neither 'working' and at the same time nor 'seeking
or available for work' for various reasons during the reference period are considered to
be 'out of labour force'. The persons under this category are students, those engaged in
domestic duties, renters, pensioners, recipients of remittances, those living on alms,
infirm or disabled persons, too young or too old persons, prostitutes, etc.

Workers have been further categorized as self-employed, regular salaried/wage employee and
casual wage labourers. These categories are defined in the following paragraphs.

Business Cycle:
The business cycle has four phases, Boom, Recession, Slump and Recovery. In economics it
has been observed that income and employment tend to fluctuate regularly overtime. These
fluctuations are known as business cycle or trade cycle. Peak / Boom: when the economy is
booming national income of the country is high and there is full employment, the
consumption and investment is high. Tax revenue is high. Wages and profits will also
increase. There will be inflationary pressure in the economy.
Recession: when the economy moves into recession, output and income fall leading to a
reduction in consumption and investment. Tax revenue begins to fall and government
expenditure begins to benefit the society. Wage demands moderate as unemployment rises,
import and inflationary pressure declines.
Trough: economic activities of the country are low, mass unemployment exists, so
consumption investment and imports will be low. Pricing may be falling (there will be
deflation)
Recovery: as the economy moves into recovery, national income and output begin to
increase. Unemployment falls, consumption, investment and import begins to rise. Workers
demand more wages and inflationary pressure begins to mount.
The fluctuation in the activities is measured with respect to a horizontal line indicating a
given steady level of economic activity. However, if the time series reveals a significant long
term trend, the vertical deviations of the reported or actual points from the estimated trend
line are measured and plotted separately to obtain a clear picture of the underlying business
cycle. Most economic variables go through ups and downs over time and the economy as a
whole experience periods of prosperity and periods of recession. The measure of prosperity is
the amount of goods/services produced (GDP) during a year. Actual business cycle are
measured by changes in real GDP, that is the market value of all the goods and services
produced within a nation’s borders, with market values measured in constant prices (prices of
a specific base year).
Expansion or boom: is the period in the business cycle from a trough up to a peak, during
which output and employment rise.
Contractions, recession, or slump: is the period in the business cycle from a peak down to a
trough, during which output and employment fall.

RECESSION
Recession is a decline in total output (real GDP) for 2 or more consecutive quarters.
Reduction in investment, employment and production, reduction in income, expenditure,
prices and profits reduction in bank loans. The business expansion stops that leads to
depression.
Depression: the level of economic activity is extremely low. The income, production,
employment, prices, profits of the country is very low. Organizations fix low price which
leads to low profit, low wages, people suffer, closing down of business.
Recovery: slow increase in output, employment, income and price. Increase in demand,
investment, bank loan, advances. This leads to recovery, revival of prosperity.

Theories on Business Cycle:

1. Sunspot theory / climate theory: depending on climatic changes agricultural products are
produced. Based on the production other ancillary units will function therefore the base for
any change in economic activity of the country is climate.
2. Psychological theory: during depression or crisis of any business organization it is
completely based on the psychology of the entrepreneur as to whether the organization can be
revived or shut down.
3. Monetary theory: means the demand and supply of money is the primary reason for
economic fluctuations of a country.
4. Over investment theory: if the organizations and individuals save more and invest a huge
amount then their expectations on increase in their returns.
5. Over savings/ under consumption theory: As per this theory the increase in savings and
investment will bring down the consumption which will reduce the demand for goods in the
market.
6. Innovation theory: According to this theory more innovations lead to new technology and
new business that leads to prosperity in the economy.
There are two types of business cycle models, they are (i) Exogenous model; due to
economic shocks like war. (ii) Endogenous model; trade cycle because of factors which lie
within the economic system. A monetarist explanation: business cycles are essentially
monetary phenomena caused by changes in the money supply. Change in money supply leads
to change in employment and national income which increases the price. The path to an
increased price level is cyclical. The link between changes in money supply and changes in
income is known as the transmission mechanism.

Inflation
Inflation is an economic condition in which the aggregate prices are always increasing in a
country. The value of money is falling. Inflation is nothing but too much of money chasing
too few goods. For example, in Zimbabwe the inflationary rate is too high as more than 1000
% and in turn they require bag full of money for a meal. And the value of their currency is
very low in the market. Inflation means not only sustainable rise in the price of the goods and
services, but the value of the currency falls in the market and the supply of money in
circulation is more. Deflation is the opposite of inflation. It is a state of disequilibrium
in which a contraction of purchasing power tends to cause or is the effect of a decline of the
price level.
Types of Inflation on The Basis of Speed:
1. Creeping inflation: the inflationary rate is less than 2% that means prices are increasing
gradually.
2. Walking inflation: the inflationary rate of a country is around 5% little more than creeping.
3. Running inflation: the rate of growth in prices are more i.e., the inflation is growing at the
rate of 10%.
4. Galloping inflation: higher growth rate compared to the earlier stages i.e. the change is
around 25%.
On the basis of Inducement:
1. Deficit induced: the deficit in the balance of payments of the country or fiscal deficit is the
reasons for inflation.
2. Wage induced: due to higher wages and salaries the money supply in the country increases
leading to inflation.
3. Profit induced: higher the profit the organizations earn, they tend to share with their
stakeholders which induces the money supply and reduces the value of money.
4. Scarcity induced: the raw material and other input factor scarcity (for example petrol) may
induce the price hike in the market.
5. Currency induced: the value of currency fluctuates due to various internal and external
forces.
6. Sectoral inflation: a particular sector of a country may be the reason for economic growth
or money supply. (for example in India the growth in service sector particularly IT)
7. Foreign trade induced: if the country has unfavourable balance of payments, that means the
country’s exports are less than the imports, then we need more of foreign currency to make
payments to the exporters ultimately this increases the demand for other currencies in the
market.
8. War time, Post war, Peace time: During war period the government expenditure on various
amenities will induce the inflation and the production, availability of the commodities will be
low which leads to price hike. To settle down the economy after war or natural calamities the
government spending will be more.
On the basis of extent of coverage:
Based on the coverage, economists classify the inflation as open and repressed;
Comprehensive and sporadic.
Effects of Inflation on Various Economic activities of the Country:
On Producers: Producers will earn more profit due to higher prices.
On debtors and creditors: Creditors will be happy to receive more returns on their lending.
On wage and salary earners: Wage holders will struggle to purchase the goods and
services.
On fixed income group: Income is fixed but the value of the currency is falling and prices
are increasing therefore it is difficult to manage the normal life. i.e. they are affected.
On investors: Investors will receive more returns on their investments.
On farmers: Farmers will suffer.
On social, moral and political effects: Due to money supply and higher the cash in hand the
social, moral values are declining in the society with political disturbances.
Demand Pull Inflation: Inflation will result if there is too much spending when compared to
output. Aggregate demand is greater than aggregate supply which leads to price hike and
inflation. An increase in aggregate demand when the economy is at less than full employment
level will result in an increase in both price and output. If the economy is at full employment
then the demand will increase which leads to inflation.
Cost Push Inflation: Inflation is caused by change in the supply side of the economy, it
increases cost of production, prices and inflation. Initially increase in costs leads to a chain of
wage increases which leads to increase in demand and cost.147
Methods Of Controlling Inflation
Control Of Inflation:
It is clear that the inflationary situation in the long run is not going to help the economy to
grow. Therefore the Government has to take many steps to overcome this problem. The given
list of measures was taken through monetary and fiscal policy of our country and is explained
in detail in the following chapters.
1.Monetary measures : to control inflation are:
Bank rate
Open market operations
Higher reserve ratio
Consumer credit control
Higher margin requirements
2.Fiscal measures:
Regulating to Government expenditure
Taxation
Public borrowing
Debt management
Over valuation of home currency
3.Others:
Wage policy
Price control measures and rationing the essential supplies Moral suasion
Anti-Inflationary Measures:
The two important tools of macro level economic policy are monetary policy and fiscal
policy. The monetary policy regulates the supply of money and availability of credit in the
economy. It deals with both the lending and borrowing rates of interest for commercial banks.
These two tools are used to control inflation and mitigate its severity.
Monetary measures: Since too much money is the fundamental problem in the economy, the
central banking authorities use various instruments to reduce the money supply and credit.
Fiscal measures: By adopting suitable measures in taxation, public expenditure and
borrowing, the government can curb inflation. The following chapter discusses these two
measures in detail.

Monetary Policy
Monetary policy is an important economic tool which is used to attain many macroeconomic
goals. Monetary policy regulates the supply of money and availability of credit in the
economy. It deals with both the lending and borrowing rates of interest of commercial banks.
It aims to maintain price stability, full employment and economic growth. Reserve Bank of
India (RBI) is responsible for formulating and implementing monetary policy of India. It was
announced twice a year (slack season and busy season) but now once in a year. It refers to the
credit control measures adopted by the central bank of a country. The efforts of monetary
authorities to increase the benefits of existing monetary system and to reduce the disabilities
in the process of economic development and growth can be called the monetary policy of
the country.
Objectives Of Monetary Policy Of India:
1. To achieve Price stability
2. To attain Exchange rate stability
3. To avoid the negative impacts of business cycle
4. To experience full employment position
Instruments: The major instruments used to achieve the above said objectives are
Bank rate: The rate of interest charged by the RBI against the commercial bank borrowings.
If RBI increases the bank rate from 2% to 3% then the commercial banks rate of interests will
go up from for example 7% to 10% which in turn reduce the public borrowings due to higher
interests and minimize the money circulation in the country.
Reserve ratio: CRR (Cash Reserve Ratio), SLR (statutory Liquidity Ratio) the RBI insist on
commercial banks to keep a certain percentage as reserve in their hands for ensuring liquidity
and regulating credit. The RBI can
increase the CRR from 3% to 15%. In case when the RBI increases CRR151 from 10% to
12% then the availability of money in the hands of banks will come down. Thus the credit
creating capacity of the commercial banks will be reduced and money supply in the market
also will be regulated. Open market operation: RBI selling the government securities to the
public. In that case instead of having money in the hands the public will receive certificates
for a fixed time period and they will receive interest against the same. But the money
circulation among the public will be reduced.
Margin requirements: Margin requirement for mortgaging against the loans will be increased
to reduce to credit and it will be reduced to increase the credit flow.
Credit rationing: The loans and advances are provided only for production purpose and for
essential activities to cut down the money in circulation.
Moral suasion: RBI controls the commercial banks for creating loans and advances by
persuasion through issue of circular.
Direct actions: Sometimes RBI takes direct action against the credit created by the banks in
contravention of the RBI guide line to overcome the inflationary situation.
Limitations Of Monetary Policy:
1. Monetary policy operates in a broad front
2. Success and failure depends on the banking system of the country
3. It has Institutional restrictions
4. Unorganized money market does not support the monetary policy
5. Existence of non monetized sector also defies RBI’s regulation
6. It is not very effective in overcoming depression.152
Monetary Policy And Economic Development:
1. Economic development needs the support of credit planning
2. Improving the efficiency of banking system
3. Decide interest rates
4. Public debt management
Monetary policy refers to various decisions and measures of the monetary authorities, state
and central bank, influencing money supply and credit situation in the monetary system as a
whole with a view to full fill certain macro economic goals. It deals with the cost of credit
and the availability of credit. Monetary policy is the attempt by the government or its agent,
the central bank, to manipulate monetary variables such as the rate of interest or the money
supply to achieve policy goals.

Fiscal Policy
Fiscal policy is defined as the conscious attempt of the government to achieve certain
macroeconomic goals of policy by altering the volume and pattern of its revenue and
expenditures and the balance between them. The major economic goals of fiscal policy are to
maintain a high average level of employment and business activity, to minimize fluctuations
in employment activity, prevent inflation and to produce and promote economic growth.
The fiscal policy is used to control inflation through making deliberate changes in
government revenue and expenditure to influence the level of output and prices. It is a
budgetary policy. Fiscal policy is the use of government taxes and spending to alter
macroeconomic outcomes of the country. During the great depression of the 1930s people
were out of work, they were unable to buy goods and services therefore government had to
increase, to regulate macroeconomic values and money supply.
The use of government spending and taxes to adjust aggregate demand is the essence of fiscal
policy. The simplest solution to the demand shortfall would be to increase government
spending. The government increases it’s spending through construction of tanks, schools,
highways. This increased spending is a fiscal stimulus. Economic stability is a macro goal of
the fiscal policy of a country whether developed or developing. By economic stabilization it
means; controlling recession or depression and price stability.
Objectives Of Fiscal Policy:
1. To maintain economic stability in the country
2. To bring Price stability
3. To achieve full employment
4. To provide social justice
5. To promote export and introduce import substitution
6. To mobilize more public revenue
7. To reallocate available resources
8. To achieve balanced regional growth.155
Instruments:
The major instruments to be used to control inflation and to achieve the above said objectives
are (i) Taxation
(ii) Public borrowings
(iii) Deficit financing.
Fiscal policy deals with the government expenditure and its composition. Government
expenditures are classified into two categories as capital expenditure and consumption
expenditure. The spending on construction of road, dams and others are called as capital
expenditure. Government expenditure on consumption of goods and services are called as
consumption expenditure. The interest paid by the government against the borrowings or
national debt is called as interest payment.
Tax Proposals On Direct Taxes:
1. Exemption limit for the general category of individual taxpayers proposed to be enhanced
from 1,80,000 to 2,00,000 giving tax relief of 2,000.
2. The upper limit of 20 per cent tax slab proposed to be raised from `8 lakh to `10 lakh.
3. Proposal to allow individual tax payers, a deduction of upto `10,000 for interest from
Savings bank accounts and upto 5,000 for preventive health check up.
4. Senior citizens not having income from business, proposed to be exempted from payment
of advance tax.
5. Restriction on Venture Capital Funds to invest only in 9 specified sectors proposed to be
removed.
6. Proposal to continue to allow repatriation of dividends from foreign subsidiaries of Indian
companies at a lower tax rate of 15 per cent upto 31.3.2013.
7. Investment link deduction of capital expenditure for certain businesses proposed to be
provided at the enhanced rate of 150 per cent.
8. New sectors to be added for the purposes of investment linked deduction.
9. Proposal to extend weighted deduction of 200 per cent for R&D157 expenditure in an in
house facility for a further period of 5 years beyond March 31, 2012.
10. Proposal to provide weighted deduction of 150 per cent on expenditure incurred for Agri-
extension services.
11. Proposal to extend the sunset date for setting up power sector undertakings by one year
for claiming 100 per cent deduction of profits for 10 years.
12. Turnover limit for compulsory tax audit of account and presumptive taxation of SMEs to
be raised from `60 lakhs to `1 crore.
13. Exemption from Capital Gains tax on sale of residential property, if sale consideration is
used for subscription in equity of a manufacturing SME for purchase of new plant and
machinery.
14. Proposal to provide weighted deduction at 150 per cent of expenditure incurred on skill
development in manufacturing sector.
15. Reduction in securities transaction tax by 20 per cent on cash delivery transactions.
16. Proposal to extend the levy of Alternate Minimum Tax to all persons, other than
Companies, claiming profit linked deductions.
17. Proposal to introduce General Anti Avoidance Rule to counter aggressive tax avoidance
scheme.
18. Measures proposed to deter the generation and use of unaccounted money.
19. A net revenue loss of `4,500 crore estimated as a result of Direct Tax proposals, Indirect
Taxes and Service Tax.
Service tax confronts challenges of its share being below its potential, complexity in tax law,
and need to bring it closer to Central Excise Law for eventual transition to GST.
Overwhelming response to the new concept of taxing services based on negative list.
1. Proposal to tax all services except those in the negative list comprising of 17 heads.
2. Exemption from service tax is proposed for some sectors.
3. Service tax law to be shorter by nearly 40 per cent.
4. Number of alignment made to harmonize Central Excise and Service Tax. A common
simplified registration form and a common return comprising of one page are steps in this
direction.
5. Revision Application Authority and Settlement Commission being introduced in Service
Tax for dispute resolution.
6. Utilization of input tax credit permitted in number of services to reduce cascading of taxes.
7. Place of Supply Rules for determining the location of service to be put in public domain
for stakeholders’ comments.
8. Study team to examine the possibility of common tax code for Central Excise and Service
Tax.
9. New scheme announced for simplification of refunds.
10. Rules pertaining to point of taxation are being rationalized.
11. To maintain a healthy fiscal situation proposal to raise service tax rate from 10 per cent to
12 per cent, with corresponding changes in rates for individual services.
12. Proposals from service tax expected to yield additional revenue of `18,660 crore.
Other Proposals for Indirect Taxes
13. Excise duty on large cars also proposed to be enhanced. No change proposed in the peak
rate of customs duty of 10 per cent on non-agricultural goods.
14. To stimulate investment relief proposals for specific sectors – especially those under
stress.
Agriculture and Related Sectors: Basic customs duty reduced for certain agricultural
equipment and their parts; Full exemption from basic customs duty for import of equipment
for expansion or setting up of fertilizer projects up to March 31, 2015.
Infrastructure: Proposal for full exemption from basic customs duty and a concessional CVD
of 1 per cent to steam coal till 31st March, 2014. Full exemption from basic duty provided to
certain fuels for power generation.
Mining: Full exemption from basic customs duty to coal mining project imports. Basic
custom duty proposed to be reduced for machinery and instruments needed for surveying and
prospecting for minerals.
Railways: Basic custom duty proposed to be reduced for equipment required for installation
of train protection and warning system and upgradation of track structure for high speed
trains.
Roads: Full exemption from import duty on certain categories of specified equipment needed
for road construction, tunnel boring machines and parts of their assembly.
Civil Aviation: Tax concessions proposed for parts of aircraft and testing equipment for third
party maintenance, repair and overhaul of civilian aircraft.
Manufacturing: Relief proposed to be extended to sectors such as steel, textiles, branded
readymade garments, low-cost medical devices, labour intensive sectors producing items of
mass consumption and matches produced by semi-mechanized units.
Health and Nutrition: Proposal to extend concessional basic customs duty of 5 per cent with
full exemption from excise duty/CVD to 6 specified life saving drugs/vaccines. Basic
customs duty and excise duty reduced on Soya products to address protein deficiency among
women and children. Basic customs duty and excise duty reduced on Iodine. Basic customs
duty reduced on Probiotics.
Environment: Concessions and exemptions proposed for encouraging the consumption of
energy-saving devices, plant and equipment needed for160 solar thermal projects. Concession
from basic customs duty and special

Globalization
Globalization means integrating the domestic economy with the world economy, moving
towards a new world economic order which leads to integrated financial markets and trade.
Globalization improves the effective allocation of resources and expenditure of a country
along with economic growth. Globalization has helped developed countries more than the
developing countries. Globalization has completely transformed the way Indian business used
to operate.
Globalization is a process of integration of the world into one market by removal of all the
political, geographical trade and business barriers among nations. Indian businesses should
formulate the following strategies to overcome the challenges posed by globalization.
1.Behavioral strategy: continuous up gradation of skills, knowledge and technology of
Human Resource is important for empowerment. Efforts should be made to develop a
comprehensive version of managerial strategy which helps to improve the decision making
skills and problem solving skills of the managers.
2.Operational strategy: producing quality products and maintaining the international quality
is essential in the globalised market. Organizations must use various methods like TQM, JIT,
Kaizen and others to improve the operational efficiency. Therefore organizations should plan
a gradual transition in technological up gradation.
3.Marketing strategy: to maximize customer satisfaction, to render better services, and to
introduce e-marketing, net marketing etc., Various marketing strategies should be followed to
improve retail environment.
4.Investment for growing FDI: Due consideration should be given to the exchange rate, other
risks like political risk and economic risk.
5.Governance: the business situation changed dramatically over the last few years. Quality is
important for sustainable development in this competitive environment. Business
opportunities are more with tough competition. Therefore good governance will maximize
the value of shareholders wealth.
6.Risk management strategy: international business is complex in nature and it leads to
various types of risks. Which can be managed by insurance, letter of credit, joint ventures,
but the top management should consider broader business strategies to define and overcome
these risks.
Effects Of Globalization On Indian Economy
1. India’s share in the world export have increased from .53% (1950) to 1 % (2005)
2. Foreign exchange reserves had increased to $180billion (2007)
3. Export growth has increased to a maximum of 20 percent per annum.
4. Current account deficit of 3% has reduced to 1.1%.
5. Reduction in external debt crisis from 8 billion in 1990 to $3billion in 2006
Benefits to consumers: Consumers were able to get large variety of goods with improved
quality at a reasonable price.
Globalizing - World Evidence:
1. Expanding Trade
2. Increasing capital flow
3. Rising tourism and migration
4. Linking of farthest corners of the world by new technology.
Forces Of Globalization:
1. Revolutionary changes have taken place in the field of Information technology.
2. Advancement in travel and transportation
3. Liberalization of trade regimes
4. Emergence of trading blocs177
Upshot Of Globalization:
1. Unprecedented economic growth
2. Multi-locational manufacturing
3. Surge in international trade
4. Explosive growth in capital movements
5. Increase in labour movement
6. Emergence of cultural commonalities
The Way Forward:
1. Build on your strength
2. Develop a global force
3. Achieve excellence in areas of one’s comparative advantage
4. Build up an effective regulatory system
5. Develop a good social security network
Thus we can conclude by saying that globalization is progressing well world over, whether
we like it or not it is bringing together different nations as one. We can see the evidence in
the Indian economy. Government of India has also taken many steps towards globalization
which has its own merits and demerits. It is evident that India has potential to face the
situation. This is the macroeconomic environment prevailing in India as well as in other parts
of the world.
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