Module-1

What Is Economics
Economics is a social science concerned with the production, distribution and consumption of
goods and services. Its basic function is to study how individuals, firms, governments and
nations make choices about how to allocate limited resources. And all the Economic problem
arises from the scarcity of resources or limitedness of resources. Every economy faces scarcity
of resources because their wants are unlimited and their resources (means) are limited.
Therefore, economic problem is the problem of economising scarce resources.

So the problem of allocation of resources arises due to the scarcity of resources, and refers to
the question of which wants should be satisfied and which should be left unsatisfied. In other
words, what to produce and how much to produce. More production of a good implies more
resources required for the production of that good, and resources are scarce. These two facts
together mean that, if a society decides to increase production of some good, it has to withdraw
some resources from the production of other goods. In other words, more production of a
desired commodity can be made possible only by reducing the quantity of resources used in the
production of other goods.

Economics has two major branches (i) Microeconomics and (ii) Macroeconomics.

i) Microeconomics- Microeconomics; is the study of particular individual household, firm or

industry, or of individual prices, wages or income.

In micro-economics we study the various constituents or parts of the economy and not as a
whole. It is in microeconomics that concept of marginal analysis assumes special importance,
as some of the important laws of microeconomics are based on it. Here, we study the economic
motives and behaviour of individual consumers and producers and the principles involved in
organizing and operating the individual firms or industries.

According to Prof. K.E. Boulding, “Microeconomics is the study of particular firms, particular
households, individual, prices, wages, incomes, individual industries, particular commodities”.
According to Brooman, “it seeks to explain the working of markets for individual commodities
and the behaviour of individual buyer and seller.”

(ii) Macroeconomics -Macroeconomics is the study of economic system as a whole. It is that

branch of economic analysis which studies the behaviour of not one particular unit, but of all the
units taken together, like total national income, output and employment, total consumption and
investment, aggregate demand and supply and general level of prices.

Macroeconomics, thus, becomes the study in aggregates and is often called ‘aggregative
economics’ as it studies the behaviour of these aggregates over time. According to Prof. K.E.
Boulding, “Macroeconomics deals not with individual quantities as such, but with aggregates of
these quantities, not with individual income but with national income, not with individual price but
with price level, not with individual output but with national output”.

Managerial Economics: Definition, Nature and Scope

Economic theories and analytical tools which are widely used in business decision making have
crystallized into a separate branch of management studies called Managerial Economics or
business Economics. Managerial economics is a discipline which deals with the application of
economic theory to business management. It deals with the use of economic concepts and
principles of business decision making. Managerial Economics may be defined as the study of
economic theories, logic and methodology which are generally applied to seek solution to the
practical problems of business. Managerial Economics is thus constituted of that part of
economic knowledge or economic theories which is used as a tool of analysing business
problems for rational business decisions.

Definition of Managerial Economics:

“Managerial economics is concerned with application of economic concepts and economic

analysis to the problems of formulating rational managerial decision.” – Mansfield

Managerial Economics is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management.” – Spencer
and Seegelman

Nature of Managerial Economics:

 The primary function of management executive in a business organisation is decision

making and forward planning under uncertain business conditions. Some of the important
management decisions are production decision, inventory decision, cost decision, marketing
decision, financial decision, personnel decision and miscellaneous decisions.
 Decision making and forward planning go hand in hand with each other. 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 also 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 function is that of the business executive, who takes the decision
which will ensure the most efficient means of attaining a desired objective, say profit
maximisation. After taking the decision about the particular output thereby pricing, capital, raw-
materials and power etc., are prepared.
 A business manager’s task is difficult by the uncertainty which surrounds business
decision-making. Nobody can predict the future course of business conditions. They have to
prepare the best possible plans for the future depending on past experience and future outlook
and yet they have to go on revising their plan 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.
 In fulfilling the function of decision-making in an uncertainty framework, economic theory
can be widely used 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 e.g. are profit, demand, cost, pricing, production and competition etc.
The way economic analysis can be used towards solving business problems, constitutes the
subject-matter of Managerial Economics.

Relation to Other Branches of Knowledge:

A useful method of throwing light on the nature and scope of managerial economics is to
examine its relationship with other disciplines.

Micro, Macro and Managerial Economics Relationship

Microeconomics studies the actions of individual consumers and firms; managerial
economics is an applied speciality of this branch. Macroeconomics deals with the
performance, structure, and behavior of an economy as a whole. Managerial economics
applies microeconomic theories and techniques to management decisions. Macroeconomists
study aggregate indicators such as national income, unemployment rates to understand the
functions of the whole economy.
Microeconomics and managerial economics both encourage the use of quantitative methods to analyze
economic data. Businesses have finite human and financial resources; managerial economic principles
can aid management decisions in allocating these resources efficiently.
Macroeconomics models and their estimates are used by the government to assist in the development
of economic policy. Macro-economics is also known as aggregative economics. It examines the
interrelations among the various aggregates, and causes of fluctuations in them. Problems of
determination of total income, total employment and general price level are the central problems in
macro-economics. Macro-economics is also related to managerial economics. The business
environment, in which a business operates, fluctuations in national income, changes in fiscal and
monetary measures and variations in the level of business activity have relevance to business decisions.
The understanding of the overall operation of the economic system is very useful to the managerial
economist in the formulation of the policies.
Managerial Economics and Theory of Decision Making:
Decision making is an integral part of today’s business management. In the entire process of
management and in each of the management activities such as planning, organizing, leading and
controlling, decision making is always essential. In fact, decision making is an integral part of today’s
business management. A manager faces a number of problems connected with business such as
production, inventory, cost, marketing, pricing, investment and personnel.
Economist are interested in the efficient use of scarce resources hence they are naturally interested in
business decision problems and they apply economics in management of business problems. Hence
managerial economics is applied in decision making.
Managerial Economics and Statistics:
Statistics is important to managerial economics. It provides the basis for the empirical testing of theory.
Statistics is important in providing the individual firm with measures of the appropriate functional
relationship involved in decision making. Statistics is a very useful science for business executives
because a business runs on estimates and probabilities.
Statistical tools are widely used in the solution of managerial problems. For example, sampling is very
useful in data collection. Managerial economics makes use of correlation and multiple regressions in
business problems involving some kind of cause and effect relationship.

Managerial Economics and Accounting:

Managerial economics is closely related to accounting. It is concerned with recording the financial
operation of a business firm. A business is started with the main aim of earning profit. Capital is invested
in business; it is employed for purchasing properties such as building, factories, etc and for meeting the
current expenses of the business.

Demand Analysis

Meaning of Demand
The demand for a commodity refers to its quantity which consumers are able and willing to buy at
various prices during a given period of time. So, for a commodity to have demand the consumer must
possess willingness to purchase it, the ability to buy it, and it must be related to per unit of time i.e. per
day, per week, per month or per year.

According to Prof. Bober, “By demand we mean the various quantities of a given commodity or service
which consumers would buy in one market in a given period of time at various prices.”

Factors determining Demand

The demand for a product is determined by different factors. The main determinants of demand are
price, income, price of related goods and advertising etc. Let us discuss the factors which influence the
individual demand for goods.

1. Price of the Commodity:

This is the basic factor influencing the demand. There is a close relationship between the quantity
demanded and the price of the product. Normally a larger quantity is demanded at a lower price and
less quantity is demanded at a higher price. There is inverse relationship between the price and quantity
demanded. This is called the law of demand.

2. Income of the Consumer:

The income of the consumer is another important factor which influences demand. The ability to buy a
commodity depends upon the income of the consumer. When the income of the consumers increases,
they can buy more and when income falls they buy less. The greater income means the greater
purchasing power.

3. Tastes and Preferences of the consumers :

The demand for a product depends upon tastes and preferences of the consumers. If the consumers
develop taste for a commodity then they buy it whatever may be the price. A favourable change in
consumer preference will cause the demand to increase. Likewise an un-favorable change in consumer
preferences will cause the demand to decrease.

4. Prices of Related Goods:

The related goods are generally substitutes and complementary goods. The demand for a product is also
influenced by the prices of substitutes and complements. When a want can be satisfied by alternative
similar goods they are called substitutes, such as coffee and tea. Whenever the price of one good and
the demand for another are inversely related then the goods are said to be complementary, such as car
and petrol.

5. Advertisement expenditure:

Advertisement made by the firm to promote the sale of its product is an important factor determining
demand for a product. In modem times, the preferences of consumers can be altered by advertisement
and sales propaganda. Advertisement helps in increasing demand by informing the potential consumers
about the availability of the product, by showing the superiority of the product.

6. Consumer’s Expectation:

A consumer s expectation about the future changes in price and income may also affect his demand. If a
consumer expects a rise in prices he may buy large quantities of that particular commodity. Similarly, if
he expects its prices to fall in future, he will tend to buy less at present. Similarly, expectation of rising
income may induce him to increase his current consumption.

Demand Function:
The demand function is an algebraic expression of the relationship between
demand for a commodity and its various determinants that affect the quantity.

Qdx = f (Px, I, Pr, T, A)

Qdx = Quantity demanded for commodity x

f = functional relation

Px = Price of commodity x

I= Income of the consumer

Pr = Prices of related commodities i.e. substitutes or complements

T = the taste and preferences of the consumer

A = the advertisement effect

The Law of Demand

The law of demand expresses a relationship between the quantity demanded and
its price. It is defined by Prof. Marshall as “the amount demanded increases
with a fall in price, and diminishes with a rise in price”. Thus it expresses an
inverse relation between price and demand. The law refers to the direction in
which quantity demanded changes with a change in price.
On the figure, it is represented by the slope of the demand curve which is normally
negative throughout its length. The inverse price- demand relationship is based on
other things remaining equal. This phrase points towards certain important
assumptions on which this law is based.

Assumptions of the Law of Demand:

i) There is no change in the tastes and preferences of the consumer

(ii) The income of the consumer remains constant

(iii) There should not be any substitutes of the commodity

(iv)There should not be any change in the prices of related products

(v) There should not be any change in the quality of the product

(vi)The habits of the consumers should remain unchanged.

An Individual Demand Schedule and Curve:

An individual consumer’s demand refers to the quantities of a commodity

demanded by him at various prices, other things remaining equal (I, Pr, A and T).

An individual’s demand for commodity is shown on the demand schedule and on

the demand curve. A demand schedule is a list of prices and quantities and its

graphic representation is a demand curve.

Demand Schedule:
Price (Rs.) Quantity (units)

6 10
 5 20

4 30

3 40

2 60

1 80

The demand schedule reveals that when the price is Rs. 6, the quantity demanded

is 10 units. If the price decreases to be Rs 5, the quantity demanded is 20 units,

and so on. In Figure 1, DD1 is the demand curve drawn on the basis of the above

demand schedule. The dotted points P, Q, R, S, T and U show the various price-

quantity combinations.

The Market Demand Schedule and Curve:

In a market, there is not one consumer but many consumers of a commodity. The market demand of a
commodity is depicted on a demand schedule and a demand curve. They show the sum total of various
quantities demanded by all the individuals at various prices.

Suppose there are three individuals A, В and С in a market who purchase the commodity. The demand
schedule for the commodity is depicted in Table 2.

The last column of the Table represents the market demand of the commodity at various prices. We can
derive the market demand by adding up the quantities demand at various prices by all the consumers, A,
В and С respectively. When the price is very high Rs. 6 per kg. the market demand for the commodity is
70 kgs. As the price falls, the demand increases. When the price is the lowest i.e. Re. 1 per kg., the
market demand per week is 360 kgs.

TABLE 2: MARKET DEMAND SCHEDULE:

Price Quantity Quantity Quantity Total

per demanded demanded demanded
kg. by A by С Demand
(Rs.) by В

6 10 20 40 70

5 20 40 60 120

4 30 60 80 170

3 40 80 100 220

2 60 100 120 280

1 80 120 160 360

From Table 2 we draw the market demand curve in Figure 10.3. D M is the market

demand curve which is the horizontal summation of all the individual demand

curves DA + DB + DC.

But a better way of drawing a market demand curve is to add together sideways

(lateral summation) of all the individual demand curves. In this case, the different

quantities demanded by consumers at one price are represented on each individual

demand curve and then a lateral summation is done, as shown in Figure 10.3.

Suppose there are three individuals A,В and С in a market who buy OA, OB and ОС

quantities of the commodity at the price OP, as shown in Panels (A), (В) and (C)

respectively in Figurel0.3. In the market, OQ quantity will be bought which is

made up by adding together the quantities OA, OB and ОС. The market demand

curve, DM is obtained by the lateral summation of the individual demand curves D A,

DB and Dc in panel (D).

Causes of Downward slopping demand curve:

The following are the main reasons for the downward sloping demand curve.

1. Price effect -Every commodity has certain consumers but when its price falls, new consumers start
consuming it, as a result demand increases. On the contrary, with the increase in the price of the
product, many consumers will either reduce or stop its consumption and the demand will be reduced.
Thus, due to the price effect when consumers consume more or less of the commodity, the demand
curve slopes downward.

2. Income effect-When the price of a commodity falls, the real income of the consumer increases
because he has to spend less in order to buy the same quantity. In other words, as a result of fall in price
of commodity, consumer’s real income or purchasing power increases. On the contrary, with the rise in
the price of the commodity, the real income of the consumer falls. This is called the income effect.
Under the influence of this effect, with the fall in the price of the commodity the consumer buys more of
it and also spends a portion of the increased income in buying other commodities.

3. Substitution effect- The other effect of change in the price of the commodity is the substitution effect.
With the fall in the price of a commodity, the prices of its substitutes remaining the same, consumers
will buy more of this commodity rather than the substitutes. As a result, its demand will increase. On the
contrary, with the rise in the price of the commodity its demand will fall, given the prices of the
substitutes. For instance, with the fall in the price of tea, the price of coffee being unchanged, the
demand for tea will rise, and on the contrary, with the increase in the price of tea, its demand will fall.
Exceptions to the Law of Demand:
In certain cases, the demand curve slopes up from left to right, i.e., it has a positive slope. Under certain
circumstances, consumers buy more when the price of a commodity rises and less when price falls, as
shown by the D curve in Figure 10.7. Many causes are attributed to an upward sloping demand curve.

(i)War:

If shortage is feared in anticipation of war, people “may start buying for building stocks or for hoarding
even when the price rises.

(ii) Giffen Paradox:

The special kind of inferior goods on which the consumers spend a big part of their income
are known as Giffen Goods. The demand for these goods increases with an increase in price
and falls with a decrease in price. This phenomenon was initially observed by Sir Robert
Giffen and is popularly known as Giffen’s Paradox. For example-If a commodity happens to be a
necessity of life like wheat and its price goes up, consumers are forced to curtail the consumption of
more expensive foods like meat and fish, and wheat being still the cheapest, food they will consume
more of it. In such goods in whose case there is a direct price-demand relation called Giffen good.

(iii)Veblen Effect

Certain types of luxury goods violate the law of demand. Veblen

goods are named after American economist Thorstein Veblen.
Generally, these are luxury goods that indicate the economic and
social status of the owner. Therefore, consumers are willing to
consume Veblen goods even more when the price increases. Some
examples of Veblen goods include luxury cars and diamond.

(iv)Necessities of Life: The commodities which are necessary for human life
have more demand no matter whether their price reduces or increases. For
example, demand for necessity goods like medicines, pulses, wheat, etc., will
increase, even if their price increases.
(v) Fear of Shortage: If the consumers expect that a commodity will become
scarce in the near future, they will start buying more of it in the present, even if
the price of the commodity rises because of the fear of its shortage and rise in
its price in the future. For example, in the initial period of COVID, consumers
demanded more of the necessity goods like wheat, pulses, etc., even at a
higher price due to their fear of general insecurity and shortage in the near
future.

Changes in Demand:

Shift in Demand: Increase in demand & decrease in demand

An individual’s demand curve is drawn on the assumption that other factors such as prices of other
commodities, income and tastes influencing his demand remain constant. What happens to an
individual’s demand curve if there is a change in any one of the factors affecting his demand? When any
one of the factors changes, the entire demand curve shifts. When an individual’s money income rises,
other factors remaining constant, his demand curve for a commodity will shift upwards to the right. He
will buy more of the commodity at a given price, as shown in Figure 10.4. Before the rise in his income,
the consumer is buying OQ1 quantity at OP price on the D1D1 demand curve.

With the increase in income, his demand curve D1D1 shifts to the right as D2D2. He now buys more
quantity OQ2 at the same price OP. When the consumer buys more of the commodity at a given price,
this is called the increase in demand. On the contrary, if his income falls, his demand curve will shift to
the left. He will buy less of the commodity at the same price, as shown in Figure 10.5. Before the fall in
his income, the consumer is on the demand curve D1D1 where he is buying OQ1 of the commodity at OP
Price. He now buys less quantity OP price at the given price OP. When the consumer buys less of the
commodity at a given price, this is called the decrease in demand.
Rather, they shift to the right or left due to a number of causes. There are changes

in tastes, habits and customs of the consumers; changes in income expenditure;

changes in the prices of substitutes and complements; expectations about future

changes in prices and incomes and changes in the age and composition of the

population, etc.

Extension and Contraction of Demand

A movement along a demand curve takes place when there is a change in the quantity demanded due to
a change in the commodity’s own price alone and other determinants remain constant here. This is
illustrated in Figure 10.6 which shows that when the price is OP 1 the quantity demanded is OQ1 with the
fall in price, there has been a downward movement along the same demand curve D 1D1 from point A to
B. This is known as extension in demand. On the contrary, if we take В as the original price-demand
point, then a rise in the price from OP2, to OP1 leads to a fall in the quantity demanded from OQ2 to OQ1.
The consumer moves upwards along the same demand curve D1D1 from point В to A. This is known as
contraction in demand.

Law of Supply

Law of supply expresses a relationship between the supply and price of a product. It states a direct
relationship between the price of a product and its supply, while other factors are kept constant. So law
of supply states that “Other things remaining unchanged, the supply of a commodity expands with a rise
in its price and contracts with a fall in its price.”

The law of supply can be better understood with the help of supply schedule, supply curve, and supply
function.

Assumptions in Law of Supply:

i. Assumes that the price of a product changes, but the change in the cost of production is
constant.
ii. Assumes that there is no change in the technique of production.
iii. Assumes that the policies of the government remain constant.
iv. Assumes that the transportation cost remain the same.

Supply Schedule:

Supply schedule shows a tabular representation of law of supply. It presents the

different quantities of a product that a seller is willing to sell at different price
levels of that product.

A supply schedule can be of two types, which are as follows:

i. Individual Supply Schedule:
Refers to a supply schedule that represents the different quantities of a product
supplied by an individual seller at different prices.

ii. Market Supply Schedule:

Refers to a supply schedule that represents the different quantities of a product
that all the suppliers in the market are willing to supply at different prices. Market
supply schedule can be drawn by aggregating the individual supply schedules of all
individual suppliers in the market.

Table-1 shows the supply schedule for the different quantities of milk
supplied in the market at different prices:

Table-1 Individual supply schedule

Price of milk Quantity supplied
10 10
12 13
14 20
16 25
In Figure, the supply curve is showing a straight line and an upward slope. This
implies that the supply of a product increases with increase in the price of a
product.

Supply Curve:
The graphical representation of supply schedule is called supply curve. In a graph, price of a product is
represented on Y-axis and quantity supplied is represented on X-axis. Supply curve can be of two types,
individual supply curve and market supply curve. Individual supply curve is the graphical representation
of individual supply schedule, whereas market supply curve is the representation of market supply
schedule.

ii. Market Supply Schedule:Refers to a supply schedule that represents the

different quantities of a product that all the suppliers in the market are willing to
supply at different prices. Market supply schedule can be drawn by aggregating
the individual supply schedules of all individual suppliers in the market.
Table-2 shows the market supply schedule of a product supplied by three
suppliers. A, B, and C:

Figure-2 shows the market supply curve of market supply schedule

(represented in Table-9):
The slope of market supply curve can be obtained by calculating the supply of the
slopes of individual supply curves. Market supply curve also represents the direct
relationship between the quantity supplied and price of a product.

Supply Function:
Supply function is the mathematical expression of law of supply. In other words,
supply function quantifies the relationship between quantity supplied and price of
a product, while keeping the other factors at constant. The law of supply expresses
the nature of relationship between quantity supplied and price of a product, while
the supply function measures that relationship.

The supply function can be expressed as:

QSx = f (Px)

Where:
QSx = Quantity supplied for product X

Px = Price of product X

f = function