UNIT-I

INTRODUCTION TO MANAGERIAL ECONOMICS

Introduction to Economics
Economics is a study of human activity both at individual and national level. The economists of early
age treated economics merely as the science of wealth. The reason for this is clear. Every one of us in
involved in efforts aimed at earning money and spending this money to satisfy our wants such as food,
Clothing, shelter, and others. Such activities of earning and spending money are called
“Economic activities”. It was only during the eighteenth century that Adam Smith, the Father of
Economics, defined economics as the study of nature and uses of national wealth‟.
Definitions:
“Economics is a study of man‟s actions in the ordinary business of life: it enquires how he gets his
income and how he uses it”. Dr. Alfred Marshall
Economics as “the study of economic welfare that can be brought directly and indirectly, into
relationship with the measuring rod of money”. Pigou
Lord Keynes defined economics as “the study of the administration of scarce means and the
determinants of employments and income”.
Microeconomics
The study of an individual consumer or a firm is called microeconomics (also called the Theory of
Firm). Micro means „one millionth‟. Microeconomics deals with behavior and problems of single
individual and of micro organization. Managerial economics has its roots in microeconomics and it
deals with the micro or individual enterprises. It is concerned with the application of the concepts
such as price theory, Law of Demand and theories of market structure and so on.
Macroeconomics
The study of „aggregate‟ or total level of economics activity in a country is called macroeconomics. It
studies the flow of economics resources or factors of production (such as land, labour, capital,
organisation and technology) from the resource owner to the business firms and then from the business
firms to the households.

Managerial Economics
Introduction
Managerial Economics as a subject gained popularity in USA after the publication of the book
“Managerial Economics” by Joel Dean in 1951.
Managerial Economics refers to the firm‟s decision making process. It could be also interpreted as
“Economics of Management” or “Economics of Management”. Managerial Economics is also called as
“Industrial Economics” or “Business Economics”.
Meaning & Definition:
In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of
economics theory and methodology to business administration practice”.
M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the integration of economic
theory with business practice for the purpose of facilitating decision making and forward planning by
management”.

Nature of Managerial Economics

The other features of managerial economics are explained as below:

(a) Close to microeconomics: Managerial economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.
1
 (b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of the
economy are also seen as limiting factors for the firm to operate.
(c) Normative statements: A normative statement usually includes or implies the words „ought‟
or „should‟. They reflect people‟s moral attitudes and are expressions of what a team of
people ought to do.
(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives
of the firm, it suggests the course of action from the available alternatives for optimal solution.
(e) Applied in nature: „Models‟ are built to reflect the real life complex business situations and
these models are of immense help to managers for decision- making. The different areas where
models are extensively used include inventory control, optimization, project management etc.
In managerial economics, we also employ case study methods to conceptualize the problem,
identify that alternative and determine the best course of action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity to
evaluate each alternative in terms of its costs and revenue. The managerial economist can
decide which is the better alternative to maximize the profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn
from different subjects such as economics, management, mathematics, statistics,
accountancy, psychology, organizational behavior, sociology and etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is based
on certain assumption and as such their validity is not universal. Where there is change in
assumptions, the theory may not hold good at all.
Scope of Managerial Economics:
The scope of managerial economics refers to its area of study. Managerial economics refers to
its area of study. Managerial economics, Provides management with a strategic planning tool that
can be used to get a clear perspective of the way the business world works and what can be done to
maintain profitability in an ever-changing environment.

1. Theory of demand and Demand Forecasting

2. Pricing and Competitive strategy

3. Production cost analysis

4. Resource allocation

5. Profit analysis

6. Capital or Investment analysis

7. Strategic planning

DEMAND ANALYSIS
Every want supported by the willingness and ability to buy constitutes demand for a particular product or
Services In other words, if I want a car and I cannot pay for it, there is no demand for the car from my
side, when three conditions are satisfied:
A product or service is said to have demand
 Desire on the part of the buyer to buy
 Willingness to pay for it
 Ability to pay the specified price for it.
Unless all these conditions are fulfilled, the product is not said to have any demand

2
Nature and Types of Demand
1. Consumer Goods vs Producer Goods
Consumer goods refers to such products and services which are capable of satisfying human need. Goods
can be grouped under consumer goods and producer goods. Consumer goods are those which are
available for ultimate consumption. These give direct and immediate satisfaction The demand for
producer goods is indirect, whereas the demand for the consumer goods is "direct".

2. Autonomous Demand vs Derived Demand

Autonomous demand refers to the demand for products and services directly. The demand for the
services of a super speciality hospital can be considered as autonomous whereas the demand for the
hotels around that hospital is called a derived demand.
3. Durable vs Perishable Goods
Here the demand for goods is classified based on their durability. Durable goods are those goods which
give service relatively for a long period. The life of perishable goods is very less, may be in hours or
days.
4. Firm Demand vs Industry Demand
The firm is a single business unit whereas industry refers to the group of firms carrying on similar
activity. The quantity of goods demanded by a single firm is called firm demand and the quantity
demanded by the industry as a whole is called industry demand.
Determinants of demand:
1. Price of commodity: The demand for any good depends on its price, more will be demanded at
lower price and vice-versa.
2. Prices of substitutes and complementariness : Demand is influenced by changes in price of
related goods either substitutes or complementary goods.
Ex: Increase in the price of coffee leads an increase in the demand for tea in the case of substitutes
positive relation and complementariness negative relationship between price and demand.
3. Income of the consumer : Demand always changes with a change in the incomes of the people.
When income increases the demand for several commodities increases and vice-versa.
4. Population : A change in the size and composition of population will effect the demand for
certain goods like food grains, clothes etc.
5. Taste and preferences: A change in the taste and the fashions bring about a change in the
demand for a commodity.
6. Technological changes: Due to economic progress technological changes the quantity the quality
of goods available to the consumers increase.
Ex : Demand for cell phones reduced the demand for landline phones.
7. Change in the weather : Demand for commodity may change due to change in a climatic
condition.
Ex : During summer demand for cool drinks, in winter demand for wollen clothes.
8. State of business : During the period of prosperity demand for commodities will expand and
during depression demand will contract.
Demand Function
Demand function is a function which describes a relationship between one variable and its determinants.
Mathematically, the demand function for a product A can be expressed as follows:
Qd=f(P.I.T. PR, Ep. Ei. Sp. DA. O)
Where
Od refers to quantity of demand and it is a function of the following variables:
P -refers to price of the product:

3
I - Income level of the consumer:
T - Tastes and preferences of the consumer.
PR - prices of related goods (substitutes/complementary)
Ep, - expectations about the prices in future:
Ei, -expectations about the incomes in future,
Sp - size of population:
D-distribution of consumers over different regions:
A - Advertising efforts and
O -other factors capable of affecting the demand
Demand schedule : It means a list of the quantities demanded at various prices in a given period of time
in a market. An imaginary example given below.

Law of Demand
The Law of Demand states: Other things remaining the same, the amount of quantity demanded rises with
every fall in the price and vice versa. The law of demand states the relationship between price and
demand of a particular product or service
It makes assumption that all other demand determinants remain the same or do not change
Law of demand : Marshall defines the law of demand as, “The amount demanded increases with a fall in
price and diminishes with arise in price when other things remain the same”. So, the law of demand
explains the inverse relationship between the price and quantity demanded of a commodity.
Demand schedule : It means a list of the quantities demanded at various prices in a given period of time
in a market. An imaginary example given below.

The table shows that as the price falls to ₹ 1/- the quantity demanded 50 units, when price ₹ 5/- he is
buying 10 units. So, there is inverse relationship between price and demand. Price is low demand will be
high and price is high demand will be low. We can illustrate the above schedule in a diagram.

4
In the above diagram on X-axis demand is shown and price is on Y-axis. DD is the ad curve. Demand
curves slopes downward from left to right.
Assumptions :
1. No change in the income of consumer
2. The taste and preferences consumers remain same.
3. The prices of related goods remain the same.
4. New substitutes are not discovered.
5. No expectation of future price changes.
Exceptions : In certain situations, more will be demanded at higher price and less will be demanded at a
lower price. In such cases the demand curve slopes upward from left to right which is called an
exceptional demand curve. This can be shown in the following diagram.

In the diagram when price increases from OP to OP 1, demand also increases from OQ to OQ 1. This is
opposite to law of demand.
1) Giffen’s Paradox: This was stated by Sir Robert Giffen. He observed that poor people will demand
more of inferior goods, if their prices raise. Inferior goods are known as Giffen goods.
Ex : Ragee, Jowar etc. He pointed out that in case of the English workers, the law of demand does not
apply to bread. Giffen noticed that workers spend a major portion of their income on bread and only
small portion on meat.
2) Veblen Effect (Prestigious goods) : This exception was stated by Veblen. Costly goods like diamonds
and precious stones are called prestige goods or veblen goods. Generally rich people purchase those
goods for the sake of prestige. Hence rich people may buy more such goods when their prices rise.

5
3) Illusion : Some times, consumer develop to false idea that a high priced good will have a better quality
instead of low priced good. If the price of such good falls, demand decreases, which is contrary to the law
of demand.
4..Fear of shortage:
During the times of emergency of war People may expect shortage of a commodity. At that time, they
may buy more at a higher price to keep stocks for the future.
5. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price

ELASTICITY OF DEMAND
The term 'elasticity' is defined as the rate of responsiveness in the demand of a commodity for a given
change in price or any other determinants of demand.
Elasticity of demand means the degree of sensitiveness or responsiveness of demand to a change in its
price.
According to Marshall “The elasticity of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price”.

Price elasticity of demand:

Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demand to a change in Price. It is the ratio of percentage change in
quantity demanded to a percentage change in price.

Proportionate change in the quantity demand of commodity

Price elasticity =
Proportionate change in the price of commodity
There are five cases of price elasticity of demand

1. Perfectly Elastic demand (Ed = ∞)

2. Perfectly Inelastic demand (Ed = 0)
3. Unitary Elastic demand (Ed = 1)
4. Relatively Elastic demand (Ed > 1)
5. Relatively Inelastic demand (Ed < 1)

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it is called
perfectly or infinitely elastic demand. In this case E=∞

6
 The demand curve DD1 is horizontal straight line. It shows the at “OP” price any amount is
demand and if price increases, the consumer will not purchase the commodity.

B. Perfectly Inelastic Demand

In this case, even a large change in price fails to bring about a change in quantity demanded.

In this case, even a large change in price fails to bring about a change in quantity demanded.
When price increases from „OP‟ to „OP‟, the quantity demanded remains the same. In other words
the response of demand to a change in Price is nil. In this case „E‟=0.
C. Relatively elastic demand:
Demand changes more than proportionately to a change in price. i.e. a small change in price loads
to a very big change in the quantity demanded. In this case
E > 1. This demand curve will be flatter.

When price falls from „OP‟ to „OP‟, amount demanded in crease from “OQ‟ to “OQ1‟ which is
larger than the change in price.
D. Relatively in-elastic demand.
Quantity demanded changes less than proportional to a change in price. A large change in price

7
 leads to small change in amount demanded. Here E < 1. Demanded carve will be steeper.

When price falls from “OP‟ to „OP1 amount demanded increases from OQ to OQ1, which is
smaller than the change in price.
E. Unit elasticity of demand:
The change in demand is exactly equal to the change in price. When both are equal E=1 and
elasticity if said to be unitary.

When price falls from „OP‟ to „OP1‟ quantity demanded increases from „OP‟ to „OP1‟, quantity
demanded increases from „OQ‟ to „OQ1‟. Thus a change in price has resulted in an equal change
in quantity demanded so price elasticity of demand is equal to unity.

Types of Elasticity
The following are the four types of elasticity of demand:
A)Price elasticity of demand
B)Income elasticity of demand
C) Cross elasticity of demand
D) Advertising elasticity of demand

These are explained below:

(a) Price Elasticity of Demand Elasticity of demand in general refers to price elasticity of demand.
In other words, it refers to the quantity demanded of a commodity in response to a given change an
price. Price elasticity is always negative which indicates that the customer tends to buy more with
every tall in the price. The relationship between the price and the demand is inverse.
It is measured as follows:
Price clasticity of demand =Proportionate change in the quantity demanded for product X /
Proportionate change in the price of X
The same is expressed as

Edp= (Q₂-Q)/Q1/(P2-P1)/P/

Where Q, is the quantity demanded before price change, Q, is quantity demanded after price
change, P is the price before change and P, is the price after change.

(b) Income Elasticity of Demand

Income elasticity of demand refers to the quantity demanded of a commodity in response to a given
change in income of the consumer.
Income elasticity is normally positive, which indicates that t consumer tends to buy more and more
with every increase in income.
It is measured as follows:
Income elasticity of demand-Proportionate change in quantity demanded for product
X/Proportionate change in income

8
 The same is expressed as

Edi =(Q2-Q1)/Q1 (I2-I1)/I1,

Where Q1, is the quantity demanded before change, Q2, is quantity demanded after change
I1, is income before change and I2, is the income after change .

(c) Cross Elasticity of Demand Cross elasticity of demand refers to the quantity demanded of a
commodity in response to a change in the price of a related good, which may be substitute or
complement.

It is measured as follows:

Proportionate change in quantity demanded for product X/ Proportionate change in price of

product Y
Edc= (Q₂-Q)/Q1/(P2y-P1y)/P1y

Where Q, is the quantity demanded before change, Q, is quantity demanded after change, P1y is the
price before change and P2y is the price after change in the case of product Y. Cross elasticity is
always positive for substitutes (which means that the demand for tea goes up if there is an increase
in the price of coffee) and negative for complements (which means that if there is increase in the
price of sugar, the demand for coffee tends to fall).

(d) Advertising Elasticity It refers to increase in the sales revenue because of change in the
advertising expenditure. In other words, there is a direct relationship between the amount of money
spent on advertising and its impact on sales. Advertising elasticity is always positive.

Advertising elasticity= Proportionate change in quantity demanded for product

X/Proportionate change in advertisement costs

The same is expressed as

Eda = (Q₂-Q₁)/Q (A₂-A)/A

Where Q, is the quantity demanded before change, Q, is quantity demanded after change A1, is the
amount spent on advertisement before change and A2, is the amount spent on advertisement after
change.

Methods of measurements of Price Elasticity of demand:

The Elasticity of demand can be measured mainly in three ways.
1. Total outlay (or) Expenditure method
2. Point method and
3. Arc method.

1) Total outlay (or) Expenditure method : This method was introduced by Alfred Marshall. Price
elasticity of demand can be measured on the basis of change in the total outlay due to a change in the
price of a commodity. This method helps us to compare the total expenditure from a buyer or total
revenue from the seller before and after the change in price.
Total outlay = Price × Quantity demanded
According to this method the price elasticity of demand is expressed in three forms, they are elastic
demand, unitary elastic and inelastic demand. This can be explained with the help of table.
9
In this table shows that
1. If the total expenditure increases due to a fall in price is known as relatively elastic demand.
2. If total expenditure remains constant even the price falls is known as unitary elastic demand.
3. If the total expenditure decreases due to a fall in price is known as relatively inelastic demand.
2) Point method : This method is introduced by Marshall. In this method elasticity of demand is
measured at a point on the demand curve. So, this method is also called as “geometrical method”. In this
method to measure elasticity at a point on demand curve the following formula is applied.
Ed = The distance from the point to the X-axis / The distance from the point to the Y-axis
In the below diagram ‘AE’ is straight line demand curve In the below diagram ‘AE’ is straight line
demand curve. Which is 10 cm length. Applying the formula we get
Ed=1,Ed<1,Ed=0

Elasticity at point A, Ed = AEA=100 = 0

10
In the diagram at C point where Elasticity of demand will be equal to CBCA.
3) Arc method : The word ‘ArC means a portion or a segment of a demand curve. In this method mid
points between the old and new price and quantities demanded are used. This method used to known
small changes in price. This method is also known as ‘Average Elasticity of demand”. This method
studies a segment of the demand curve between two points the formula for measuring elasticity is given
below.

Demand Forecasting
It is a technique for estimation of probable demand for a product or services in the future. It is based on
the analysis of past demand for that product or service in the present market condition. Demand
forecasting should be done on a scientific basis and facts and events related to forecasting should be
considered.
Methods of forecasting:
Several methods are employed for forecasting demand. All these methods can be grouped under survey
method and statistical method. Survey methods and statistical methods are further subdivided in to
different categories.
1. Survey Method:
Under this method, information about the desires of the consumer and opinion of exports are collected by
interviewing them. Survey method can be divided into four type‟s viz., Option survey method; expert
opinion; Delphi method and consumers interview methods.
a. Opinion survey method:

11
This method is also known as sales-force composite method (or) collective opinion method. Under this
method, the company asks its salesman to submit estimate of future sales in their respective territories.
Since the forecasts of the salesmen are biased due to their optimistic or pessimistic attitude ignorance
about economic developments etc. these estimates are consolidated, reviewed and adjusted by the top
executives. In case of wide differences, an average is struck to make the forecasts realistic.
This method is more useful and appropriate because the salesmen are more knowledge. They can be
important source of information. They are cooperative. The implementation within unbiased or their basic
can be corrected.
B. Expert opinion method:
Apart from salesmen and consumers, distributors or outside experts may also e used for forecasting. In
the United States of America, the automobile companies get sales estimates directly from their dealers.
Firms in advanced countries make use of outside experts for estimating future demand. Various public
and private agencies all periodic forecasts of short or long term business conditions.
C. Delphi Method:
A variant of the survey method is Delphi method. It is a sophisticated method to arrive at a consensus.
Under this method, a panel is selected to give suggestions to solve the problems in hand. Both internal
and external experts can be the members of the panel. Panel members one kept apart from each other and
express their views in an anonymous manner. There is also a coordinator who acts as an intermediary
among the panelists. He prepares the questionnaire and sends it to the panelist. At the end of each round,
he prepares a summary report. On the basis of the summary report the panel members have to give
suggestions. This method has been used in the area of technological forecasting. It has proved more
popular in forecasting. It has provided more popular in forecasting non- economic rather than economic
variables.
D. Consumers interview method:
In this method the consumers are contacted personally to know about their plans and preference regarding
the consumption of the product. A list of all potential buyers would be drawn and each buyer will be
approached and asked how much he plans to buy the listed product in future. He would be asked the
proportion in which he intends to buy. This method seems to be the most ideal method for forecasting
demand.

2. Statistical Methods:
Statistical method is used for long run forecasting. In this method, statistical and mathematical techniques
are used to forecast demand. This method relies on post data.
a. Time series analysis or trend projection methods:
A well-established firm would have accumulated data. These data are analyzed to determine the nature of
existing trend. Then, this trend is projected in to the future and the results are used as the basis for
forecast. This is called as time series analysis. This data can be presented either in a tabular form or a
graph. In the time series post data of sales are used to forecast future.
b. Barometric Technique:
Simple trend projections are not capable of forecasting turning paints. Under Barometric method, present
events are used to predict the directions of change in future. This is done with the help of economics and
statistical indicators. Those are (1) Construction Contracts awarded for building materials (2) Personal
income (3) Agricultural Income. (4) Employment (5) Gross national income (6) Industrial Production (7)
Bank Deposits etc.
c. Regression and correlation method:
Regression and correlation are used for forecasting demand. Based on post data the future data trend is
forecasted. If the functional relationship is analyzed with the independent variable it is simple correction.
When there are several independent variables it is multiple correlation. In correlation we analyze the
nature of relation between the variables while in regression; the extent of relation between the variables is
analyzed. The results are expressed in mathematical form. Therefore, it is called as econometric model
building. The main advantage of this method is that it provides the values of the independent variables
from within the model itself.

12