Managerial Economics – An Insight

1
Index

Chapter 1 Basics of Managerial Economics 3 - 14

Chapter 2 Demand, Supply and Market Equilibrium 15 - 20

Chapter 3 Production and Cost Analysis 21 - 23

Chapter 4 Market Structures 24 – 26

Questions 27

2
Chapter 1 – Basics of Managerial Economics

Economics is a social science. Its basic function is to study how people – individuals, households, firms
and nations – maximize their gains from their limited or scarce resources and opportunities.

Micro Economics - Microeconomics looks at the smaller picture of the economy and is the study of the
behavior of small economic units.

Macro Economics – It is the branch of economic analysis that deals with the study of aggregates.

Microeconomics deals with the firms level and takes into consideration the decision making power of
individual units whereas macroeconomics deals with the economy level and takes into consideration
the impact of government policies on the aggregates like national income and employment.

Managerial Economics

Managerial Economics and Business economics are the two terms, which, at times have been used
interchangeably. Of late, however, the term Managerial Economics has become more popular and
seems to displace progressively the term Business Economics.

The prime function of a management executive in a business organization is decision making and
forward planning. Decision Making means the process of selecting one action from two or more
alternative courses of action whereas forward planning means establishing plans for the future. The
question of choice arises because resources such as capital, land, labour and management are limited
and can be employed in alternative uses. The decision making function thus becomes one of making
choices or decisions that will provide the most efficient means of attaining a desired end, say, profit
maximization. Once decision is made about the particular goal to be achieved, plans as to production,
pricing, capital, raw materials, labour, etc., are prepared. Forward planning thus goes hand in hand with
decision making.

3
A significant characteristic of the conditions, in which business organizations work and take decisions, is
uncertainty. And this fact of uncertainty not only makes the function of decision making and forward
planning complicated but adds a different dimension to it. If knowledge of the future were perfect, plans
could be formulated without error and hence without any need for subsequent revision. In the real
world, however, the business manager rarely has complete information and the estimates about future
predicted as best as possible. As plans are implemented over time, more facts become known so that in
their light, plans may have to be revised, and a different course of action adopted. 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
pressed into service with considerable advantage. Economic theory deals with a number of concepts
and principles relating, for example, to profit, demand, cost, pricing production, competition, business
cycles, national income, etc., which aided by allied disciplines like Accounting. Statistics and
Mathematics can be used to solve or at least throw some light upon the problems of business
management. The way economic analysis can be used towards solving business problems. Constitutes
the subject matter of Managerial Economics.

Definition of Managerial Economics

According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of
thought to analyse business situation."

Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning by
management."

We may, therefore define Managerial Economics as the discipline which deals with the application of
economic theory to business management. Managerial Economics thus lies on the borderline between
economics and business management and serves as a bridge between economics and business
management.

4
 Chart 1 – Economics, Business Management and Managerial Economics.

Application of Economics to Business Management

The application of economics to business management or the integration of economic theory with
business practice, as Spencer and Siegelman have put it, has the following aspects :-

1. Reconciling traditional theoretical concepts of economics in relation to the actual business

behavior and conditions. In economic theory, the technique of analysis is one of model building
whereby certain assumptions are made and on that basis, conclusions as to the behavior of the firms
are drown. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a
satisfactory explanation of that what the firms actually do. Hence the need to reconcile the theoretical
principles based on simplified assumptions with actual business practice and develops appropriate
extensions and reformulation of economic theory, if necessary.
2. Estimating economic relationships, viz., measurement of various types of elasticities of demand
such as price elasticity, income elasticity, cross-elasticity, promotional elasticity, cost-output
relationships, etc. The estimates of these economic relationships are to be used for purposes of
forecasting.
3. Predicting relevant economic quantities, eg., profit, demand, production, costs, pricing, capital,
etc., in numerical terms together with their probabilities. As the business manager has to work in an
environment of uncertainty, future is to be predicted so that in the light of the predicted estimates,
decision making and forward planning may be possible.
4. Using economic quantities in decision making and forward planning, that is, formulating
business policies and, on that basis, establishing business plans for the future pertaining to profit,
prices, costs, capital, etc. The nature of economic forecasting is such that it indicates the degree of
probability of various possible outcomes, i.e. losses or gains as a result of following each one of the
strategies available. Hence, before a business manager there exists a quantified picture indicating the
number o courses open, their possible outcomes and the quantified probability of each outcome.
Keeping this picture in view, he decides about the strategy to be chosen.

5
5. Understanding significant external forces constituting the environment in which the business is
operating and to which it must adjust, e.g., business cycles, fluctuations in national income and
government policies pertaining to public finance, fiscal policy and taxation, international economics
and foreign trade, monetary economics, labour relations, anti-monopoly measures, industrial
licensing, price controls, etc. The business manager has to appraise the relevance and impact of these
external forces in relation to the particular business unit and its business policies.

Characteristics of Managerial Economics

It would be useful to point out certain chief characteristics of Managerial Economics, in as much it’s they
throw further light on the nature of the subject matter and help in a clearer understanding thereof.

1. Managerial Economics is micro-economic in character.

2. Managerial Economics largely uses that body of economic concepts and principles, which is
known as 'Theory of the firm' or 'Economics of the firm'. In addition, it also seeks to apply Profit
Theory, which forms part of Distribution Theories in Economics.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but
involves complications ignored in economic theory to face the overall situation in which decisions are
made. Economic theory appropriately ignores the variety of backgrounds and training found in
individual firms but Managerial Economics considers the particular environment of decision making.
4. Managerial Economics belongs to normative economics rather than positive economics (also
sometimes known as Descriptive Economics). In other words, it is prescriptive rather than descriptive.
The main body of economic theory confines itself to descriptive hypothesis, attempting to generalize
about the relations among different variables without judgment about what is desirable or
undesirable. For instance, the law of demand states that as price increases. Demand goes down or
vice-versa but this statement does not tell whether the outcome is good or bad. Managerial
Economics, however, is concerned with what decisions ought to be made and hence involves value
judgments.

Production and Supply

Production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in
physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with
different production functions and their managerial uses.

Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply
analysis are supply schedule, curves and function, law of supply and its limitations. Elasticity of supply
and Factors influencing supply.

Pricing Decisions, Policies and Practices

Pricing is a very important area of Managerial Economics. In fact, price is the life blood of the revenue of
a firm and as such the success of a business firm largely depends on the correctness of the prices
decisions taken by it. The important aspects dealt with under this area are :- Price Determination in
various Market Forms, Pricing methods, Differential Pricing, Product-line Pricing and Price Forecasting.

6
Profit Management

Business firms are generally organized for the purpose of making profits and, in long run, profits provide
the chief measure of success. In this connection, an important point worth considering is the element of
uncertainty exiting about profits because of variations in costs and revenues which, in turn, are caused
by torso both internal and external to the firm. If knowledge about the future were fact, profit analysis
would have been a very easy task. However, in a world of certainty, expectations are not always realized
so that profit planning and measurement constitute the difficult are of Managerial Economics. The
important acts covered under this area are :- Nature and Measurement of Profit, Profit Testing and
Techniques of Profit Planning like Break-Even Analysis.

Capital Management

Of the various types and classes of business problems, the most complex and able some for the business
manager are likely to be those relating to the firm’s investments. Relatively large sums are involved, and
the problems are so complex that their disposal not only requires considerable time and labour but is a
term for top-level decision. Briefly, capital management implies planning and trolls of capital
expenditure. The main topics dealt with are :- Cost of Capital, Rate return and Selection of Project.

The various aspects outlined above represent the major uncertainties which a ness firm has to reckon
with, viz., demand uncertainty, cost uncertainty, price certainty, profit uncertainty, and capital
uncertainty. We can, therefore, conclude the subject matter of Managerial Economic consists of
applying economic cripples and concepts towards adjusting with various uncertainties faced by a ness
firm.

Managerial Economics and Other Subjects

Yet another useful method of throwing light upon the nature and scope of Managerial Economics is to
examine its relationship with other subjects. In this connection, Economics, Statistics, Mathematics and
Accounting deserve special mention.

Managerial Economics and Economics

Managerial Economics has been described as economics applied to decision making. It may be viewed as
a special branch of economics bridging the gulf between pure economic theory and managerial practice.

Economics has two main divisions :- (i) Microeconomics and (ii) Macroeconomics. Microeconomics has
been defined as that branch of economics where the unit of study is an individual or a firm.
Macroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit of
study.

Microeconomics, also known as price theory (or Marshallian economics) is the main source of concepts
and analytical tools for managerial economics. To illustrate various micro-economic concepts such as
elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., all are of
great significance to managerial economics. The chief contribution of macroeconomics is in the area of

7
 forecasting. The modern theory of income and employment has direct implications for forecasting
general business conditions. As the prospects of an individual firm often depend greatly on general
business conditions, individual firm forecasts depend on general business forecasts.

A survey in the has shown that business economists have found the following economic concepts quite
useful and of frequent application :-

1. Price elasticity of demand,

2. Income elasticity of demand,
3. Opportunity cost,
4. The multiplier,
5. Propensity to consume,
6. Marginal revenue product,
7. Speculative motive,
8. Production function,
9. Balanced growth, and
10. Liquidity preference.

Business economics have also found the following main areas of economics as useful in their work :-

1. Demand theory,
2. Theory of the firm-price, output and investment decisions,
3. Business financing,
4. Public finance and fiscal policy,
5. Money and banking,
6. National income and social accounting,
7. Theory of international trade, and
8. Economics of developing countries.

Managerial Economics and Management Accounting

Managerial Economics is also closely related to accounting, which is concerned with recording the
financial operations of a business firm. Indeed, accounting information is one of the principal sources of
data required by a managerial economist for his decision making purpose. For instance, the profit and
loss statement of a firm tells how well the firm has done and the information it contains can be used by
managerial economist to throw significant light on the future course of action - whether it should
improve or close down. Of course, accounting data call for careful interpretation. Recasting and
adjustment before they can be used safely and effectively.

It is in this context that the growing link between management accounting and managerial economics
deserves special mention. The main task of management accounting is now seen as being to provide the
sort of data which managers need if they are to apply the ideas of managerial economics to solve
business problems correctly; the accounting data are also to be provided in a form so as to fit easily into
the concepts and analysis of managerial economics.

Uses of Managerial Economics

8
 Managerial economics accomplishes several objectives.

First, it presents those aspects of traditional economics, which are relevant for business decision making
it real life. For the purpose, it calls from economic theory the concepts, principles and techniques of
analysis which have a bearing on the decision making process. These are, if necessary, adapted or
modified with a view to enable the manager take better decisions. Thus, managerial economics
accomplishes the objective of building suitable tool kit from traditional economics.

Secondly, it also incorporates useful ideas from other disciplines such a psychology, sociology, etc., if
they are found relevant for decision making. In fact managerial economics takes the aid of other
academic disciplines having a bearing upon the business decisions of a manager in view of the carious
explicit and implicit constraints subject to which resource allocation is to be optimized.

Thirdly, managerial economics helps in reaching a variety of business decisions.

1. What products and services should be produced?

2. What inputs and production techniques should be used?
3. How much output should be produced and at what prices it should be sold?
4. What are the best sizes and locations of new plants?
5. How should the available capital be allocated?

Fourthly, managerial economics makes a manager a more competent model builder. Thus he can
capture the essential relationships which characterize a situation while leaving out the cluttering details
and peripheral relationships.

Fifthly, at the level of the firm, where for various functional areas functional specialists or functional
departments exist, e.g., finance, marketing, personal production, etc., managerial economics serves as
an integrating agent by coordinating the different areas and bringing to bear on the decisions of each
department or specialist the implications pertaining to other functional areas. It thus enables business
decision making not in watertight compartments but in an integrated perspective, the significance of
which lies in the fact that the functional departments or specialists often enjoy considerable autonomy
and achieve conflicting coals.

Finally, managerial economics takes cognizance of the interaction between the firm and society and
accomplishes the key role of business as an agent in the attainment of social and economic welfare. It
has come to be realized that business part from its obligations to shareholders has certain social
obligations. Managerial economics focuses attention on these social obligations as constraints subject to
which business decisions are to be taken. In so doing, it serves as an instrument in rehiring the economic
welfare of the society through socially oriented business decisions.

Role and Responsibilities of Managerial Economist

A managerial economist can play a very important role by assisting the Management in using the
increasingly specialized skills and sophisticated techniques which are required to solve the difficult
problems of successful decision making and forward planning. That is why, in business concerns, his
importance is being growingly recognized. In developed countries like the U.S.A., large companies
employ one or more economists. In our country (India) too, big industrial houses have come to

9
 recognize the need for managerial economists, and there are frequent advertisements for such
positions. Tatas and Hindustan Lever employ economists. Indian Petrochemicals Corporation Ltd., a
Government of India undertaking, also keeps an economist.

Let us examine in specific terms how a managerial economist can contribute to decision making in
business.

In this connection, two important questions need be considered :-

1. What role does he play in business, that is, what particular management problems lend
themselves to solution through economic analysis?
2. How can the managerial economist best serve management, that is, what are the
responsibilities of a successful managerial economist?

Role of Managerial Economist

One of the principal objectives of any management in its decision making process is to determine the
key factors which will influence the business over the period ahead. In general, these factors can be
divided into two category, viz., (i) External and (ii) Internal. The external factors lie outside the control
management because they are external to the firm and are said to constitute business environment. The
internal factors lie within the scope and operations of a firm and hence within the control of
management, and they are known as business operations.

To illustrate, a business firm is free to take decisions about what to invest, where to invest, how much
labour to employ and what to pay for it, how to price its products and so on but all these decisions are
taken within the framework of a particular business environment and the firm’s degree of freedom
depends on such factors as the government’s economic policy, the actions of its competitors and the
like.

Environmental Studies

An analysis and forecast of external factors constituting general business conditions, e.g., prices,
national income and output, volume of trade, etc., are of great significance since every business from is
affected by them.

Certain important relevant questions in this connection are as follows :-

1. What is the outlook for the national economy? What are the most important local, regional or
worldwide economic trends? What phase of the business cycle lies immediately ahead?
2. What about population shifts and the resultant ups and downs in regional purchasing power?
3. What are the demands prospects in new as well as established markets? Will changes in social
behavior and fashions tend to expand or limit the sales of a company’s products, or possibly make the
products obsolete?
4. Where are the market and customer opportunities likely to expand or contract most rapidly?
5. Will overseas markets expand or contract, and how will new foreign government legislation’s
affect operation of the overseas plants?

10
6. Will the availability and cost of credit tend to increase or decrease buying? Are money or credit
conditions ahead likely to be easy or tight?
7. What the prices of raw materials and finished products are likely to be?
8. Is competition likely to increase or decrease?
9. What are the main components of the five-year plan? What are the areas where outlays have
been increased? What are the segments, which have suffered a cut in their outlay?
10. What is the outlook regarding government’s economic policies and regulations?
11. What about changes in defense expenditure, tax rates, tariffs and import restrictions?
12. Will Reserve Bank’s decisions stimulate or depress industrial production and consumer
spending? How will these decisions affect the company’s cost, credit, sales and profits?

Reasonably accurate answers to these and similar questions can enable management to chalk out more
wisely the scope and direction of their own business plans and to determine the timing of their specific
actions. And it is these questions which present some of the areas where a managerial economist can
make effective contribution.

The managerial economist has not only to study the economic trends at the macro level but must also
interpret their relevance to the particular industry / firm where he works. He has to digest the ever
growing economic literature and advise top management by means of short, business like practical
notes.

In a mixed economy like India, the managerial economist pragmatically interprets the intentions of
controls and evaluates their impact. He acts as a bridge between the government and the industry,
translating the government’s intentions and transmitting the reactions of the industry. In fact,
government policies charge out of the performance of industry, the expectations of the people and
political expediency.

Business Operations

A managerial economist can also be helpful to the management in making decisions relating to the
internal operations of a firm in respect of such problems as price, rate of operations, investment,
expansion or contraction.

Certain relevant questions in this context would be as follows :-

1. What will be a reasonable sales and profit budget for the next year?
2. What will be the most appropriate production Schedules and inventory policies for the next six
months?
3. What changes in wage and price policies should be made now?
4. How much cash will be available next month and how should it be invested?

Specific Functions

A further idea of the role of managerial economists can be seen from the following specific functions
performed by them as revealed by a survey pertaining to Britain conducted by K.J.W. Alexander and
Alexander G. Kemp :-

11
1. Sales forecasting.
2. Industrial market research.
3. Economic analysis of competing companies.
4. Pricing problems of industry.
5. Capital projects.
6. Production programs.
7. Security/investment analysis and forecasts.
8. Advice on trade and public relations.
9. Advice on primary commodities.
10. Advice on foreign exchange.
11. Economic analysis of agriculture.
12. Analysis of underdeveloped economics.
13. Environmental forecasting.

The managerial economist has to gather economic data, analyze all pertinent information about the
business environment and prepare position papers on issues facing the firm and the industry. In the case
of industries prone to rapid technological advances, he may have to make a continuous assessment of
the impact of changing technology. He may have to evaluate the capital budget in the light of short and
long-range financial, profit and market potentialities. Very often, he may have to prepare speeches for
the corporate executives.

It is thus clear that in practice managerial economists perform many and varied functions. However, of
these, marketing functions, i.e., sales forecasting and industrial market research, has been the most
important. For this purpose, they may compile statistical records of the sales performance of their own
business and those relating to their rivals, carry our analysis of these records and report on trends in
demand, their market shares, and the relative efficiency of their retail outlets. Thus while carrying out
their functions; they may have to undertake detailed statistical analysis. There are, of course, differences
in the relative importance of the various functions performed from firm to firm and in the degree of
sophistication of the methods used in carrying them out. But there is no doubt that the job of a
managerial economist requires alertness and the ability to work under pressure.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerial economist may also provide general
intelligence service supplying management with economic information of general interest such as
competitors prices and products, tax rates, tariff rates, etc. In fact, a good deal of published material is
already available and it would be useful for a firm to have someone who understands it. The managerial
economist can do the job with competence.

Participating in Public Debates

Many well-known business economists participate in public debates. Their advice and views are being
sought by the government and society alike. Their practical experience in business and industry ads
stature to their views. Their public recognition enhances their stature in the organization itself.

Indian Context

12
 In the Indian context, a managerial economist is expected to perform the following functions :-

1. Macro-forecasting for demand and supply.

2. Production planning at macro and micro levels.
3. Capacity planning and product-mix determination.
4. Economics of various productions lines.
5. Economic feasibility of new production lines/processes and projects.
6. Assistance in preparation of overall development plans.
7. Preparation of periodical economic reports bearing on various matters such as the company’s
product-lines, future growth opportunities, market pricing situation, general business, and various
national/international factors affecting industry and business.
8. Preparing briefs, speeches, articles and papers for top management for various Chambers,
Committees, Seminars, Conferences, etc.
9. Keeping management informed o various national and international developments on
economic/industrial matters.

With the adoption of the New Economic Policy, in 1991, the macro-economic Environment in India is
changing fast at a pace that has been rarely witnessed before. And these changes have tremendous
implications for business. The managerial economist has to play a much more significant role. He has to
constantly gauge the possibilities of translating the rapidly changing economic scenario into viable
business opportunities. As India marches towards globalization, he will have to interpret the global
economic events and find out how his firm can avail itself of the carious export opportunities or of
establishing plants abroad either wholly owned or in association with local partners.

Responsibilities of Managerial Economist

Having examined the significant opportunities before a managerial economist to contribute to

managerial decision making, let us now examine how he can best serve the management. For this, he
must thoroughly recognize his responsibilities and obligations.

A managerial economist can serve management best only if he always keeps in mind the main objective
of his business, viz., to make a profit on its invested capital. His academic training and the critical
comments from people outside the business may lead a managerial economist to adopt an apologetic or
defensive attitude towards profits. Once management notices this, his effectiveness is almost sure to be
lost. In fact, he cannot expect to succeed in serving management unless he has a strong personal
conviction that profits are essential and that his chief obligation is to help enhance the ability of the firm
to make profits.

Most management decisions necessarily concern the future, which is rather uncertain. It is, therefore,
absolutely essential that a managerial economist recognizes his responsibility to make successful
forecasts. By making best possible forecasts and through constant efforts to improve upon them, he
should aim at minimizing, if not completely eliminating, the risks involved in uncertainties, so that the
management can follow a more orderly course of business planning. At times, he will have to reassure
the management that an important trend will continue; in other cases, he may have to point out the
probabilities of a turning point in some activity of importance to management. In any case, he must be
willing to make considered but fairly positive statements about impending economic developments,
based upon the best possible information and analysis and stake his reputation upon his judgment.

13
Nothing will build management confidence in a managerial economist more quickly and thoroughly than
a record of successful forecasts, well-documented in advance and modestly evaluated when the actual
results become available.

A few corollaries to the above proposition need also be emphasized here.

First, he has a major responsibility to "alert management at the earliest possible moment" in case he
discovers an error in his forecast. By promptly drawing attention to changes in forecasting conditions, he
will not only assist management in making appropriate adjustment in policies and programs but will also
be able to strengthen his own position as a member of the management team by keeping his fingers on
the economic pulse of the business.

Secondly, he must establish and maintain many contacts with individuals and data sources, which would
not be immediately available to the other members of the management. Extensive familiarity with
reference sources and material is essential, but it is still more important that he knows individuals who
are specialists in particular fields having a bearing on his work. For this purpose, he should join
professional associations and take active part in them. In fact, one of the best means of determining the
caliber of a managerial economist is to evaluate his ability to obtain information quickly by personal
contacts rather than by lengthy research from either readily available or obscure reference sources.
Within any business, there may be a wealth of knowledge and experience but the managerial economist
would be really useful if he can supplement the existing know-how with additional information and in
the quickest possible manner.

Again, if a managerial economist is to be really helpful to the management in successful decision making
and forward planning, he must be able to earn full status on the business team. He should be ready and
even offer himself to take up special assignments, be that in study teams, committees or special
projects. For, a managerial economist can only function effectively in an atmosphere where his success
or failure can be traced not only to his basic ability, training and experience, but also to his personality
and capacity to win continuing support for himself and his professional ideas. Of course, he should be
able to express himself clearly and simply and must always try to minimize the use of technical
terminology in communicating with his management executives. For, it is well-known that if
management does not understand, it will almost automatically reject. Further, while intellectually he
must be in tune with industry’s thinking the wider national perspective should not be absents from his
advice to top management.

14
Chapter 2 : Demand, Supply and Market Equillibrium

Definition: The law of demand states that other factors being constant (cetris peribus), price and
quantity demand of any good and service are inversely related to each other. When the price of a
product increases, the demand for the same product will fall.

Description: Law of demand explains consumer choice behavior when the price changes. In the market,
assuming other factors affecting demand being constant, when the price of a good rises, it leads to a fall
in the demand of that good. This is the natural consumer choice behavior. This happens because a
consumer hesitates to spend more for the good with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping. Clearly when the price of the
commodity increases from price p3 to p2, then its quantity demand comes down from Q3 to Q2 and
then to Q3 and vice versa.

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy. Demand refers to how much (quantity) of a product or service is
desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a
certain price; the relationship between price and quantity demanded is known as the demand
relationship. Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The correlation
between price and how much of a good or service is supplied to the market is known as the supply
relationship. Price, therefore, is a reflection of supply and demand.

15
The relationship between demand and supply underlie the forces behind the allocation of resources. In
market economy theories, demand and supply theory will allocate resources in the most efficient way
possible. How? Let us take a closer look at the law of demand and the law of supply.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good, the less
people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes
up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value more. The chart
below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between
quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will
be P1, and so on. The demand relationship curve illustrates the negative relationship between price and
quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower
the price, the more the good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the
higher the price, the higher the quantity supplied. Producers supply more at a higher price because

16
selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between
quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2,
and so on.
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important
to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it
is important to try and determine whether a price change that is caused by demand will be temporary or
permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas year-round,
the change in demand and price will be expected to be long term; suppliers will have to change their
equipment and production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply and
demand affect price.

17
Imagine that a special edition CD of your favorite band is released for $20. Because the record
company's previous analysis showed that consumers will not demand CDs at a price higher than $20,
only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If,
however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to
the demand relationship, as demand increases, so does the price. Consequently, the rise in price should
prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher
the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up
because the supply more than accommodates demand. In fact after the 20 consumers have been
satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell
the remaining ten CDs. The lower price will then make the CD more available to people who had
previously decided that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the
economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because
the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus,
everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given
price, suppliers are selling all the goods that they have produced and consumers are getting all the
goods that they are demanding.

18
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve,
which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity
will be Q*. These figures are referred to as equilibrium price and quantity.
In the real market place equilibrium can only ever be reached in theory, so the prices of goods and
services are constantly changing in relation to fluctuations in demand and supply.

Different types of Elasticity of Demand:

1. Price Elasticity of Demand Formula = % change in demand / % change in price
2. Income Elasticity of Demand Formula = % change in demand / % change in income
3. Cross Elasticity of Demand Formula = % change in demand ( X) / % change in price ( Y)
4. Advertisement Elasticity of Demand Formula = % change in demand / % change in Advt. Budget

1. Price Elasticity of Demand:

We will discuss how sensitive the change in demand is to the change in price. The measurement of this
sensitivity in terms of percentage is called price Elasticity of Demand. According to Marshall, Price
Elasticity of Demand is the degree of responsiveness of demand to the change in price of that
commodity.
2. Income elasticity of demand:
In economics, the income elasticity of demand measures the responsiveness of the quantity demanded
of a good to the change in the income of the people demanding the good. It is calculated as the ratio of
the percent change in quantity demanded to the percent change in income. For example, if, in response
to a 10% increase in income, the quantity of a good demanded increased by 20%, the income elasticity
of demand would be 20%/10% = 2.
3. Cross elasticity of demand:
In economics, the cross elasticity of demand and cross price elasticity of demand measures the
responsiveness of the quantity demand of a good to a change in the price of another good.

It is measured as the percentage change in quantity demanded for the first good that occurs in response
to a percentage change in price of the second good. For example, if, in response to a 10% increase in the
price of fuel, the quantity of new cars that are fuel inefficient demanded decreased by 20%, the cross
elasticity of demand would be -20%/10% = -2.

19
4. Advertisement Elasticity of Demand:
The degree of responsiveness of quantity demanded to the change in the advertisement expense of
expenditure.
Ea= Change in quantity demanded x original advertisement expenses
Change in advertisement expenses original quantity demanded

20
 Chapter 3: Basic concepts of production and cost theory

         Production is the creation of goods and services from inputs or resources, such as labor, machinery
and other capital equipment, land, raw materials, and so on.
         Production function is the relationship between the quantity of inputs and quantity of outputs. It is
a schedule (or table or mathematical equation) showing the maximum amount of output that can
be produced from any specified set of inputs, given the existing technology.

Many different inputs are used in production. We can define the maximum output to be a
function of the level of usage of the various inputs. That is,

       Where are inputs.

But in our discussion we will generally restrict our attention to the simpler case of a product whose
production entails only one or two inputs. We will normally use capital and labor as the two inputs.

Hence, the production function we will usually be concerned with is:

Technical efficiency and economic efficiency

       Technical efficiency is achieved when the maximum possible amount of output is being
produced with a given combination of inputs. The definition of a production function assumes
that technical efficiency is being achieved for any particular combination of inputs. Thus
technical efficiency is implied by the production function.
        Economic efficiency is achieved when the firm is producing a given amount of output at the
lowest possible cost.
         Short run and long run: When analyzing the process of production, it is convenient to introduce
the classification of inputs as fixed or variable.
        A fixed input is one for which the level of usage cannot readily be changed. No input is ever
absolutely fixed. However, the cost of immediately varying the use of input may be so great

21
 that, for all practical purposes, the input is fixed. For example, buildings, major pieces of
machinery, and managerial personnel are considered fixed inputs.
       A variable input is one for which the level of usage may be changed quite readily in response
to desired changes in output. Many types of labor services as well as certain raw and processed
materials would be in this category.
       Short run refers to that period of time in which the level of usage of one or more of the inputs
is fixed. Therefore, in the short run, changes in output must be accomplished exclusively by
changes in the use of the variable inputs. In the context of our simplified production function,
we might considered capital to be the fixed input and write the resulting short-run production

function as:
      Long run is defined as that period of time ( or planning horizon ) in which all inputs are
variable.
         Fixed or variable proportions: most of the discussion in this chapter and next chapter refers to
production functions that allow at least some substitution of one input for another in reaching
an output target.
       Variable proportions: When substitution is possible, we say inputs may be used in variable
proportions. As a consequence, producer must determine not only the optimal level of output
but also the optimal combination of input. Variable proportions production means that output
can be changed in the short run by changing the variable inputs without changing the fixed
inputs. And it means that the same output can be produced using different combinations of
inputs.
        Fixed proportions production means that there is one, and only one, ratio or mix of inputs that
can be used to produce a good. If output is expanded or contracted, all inputs must be
expanded or contracted. In such cases, the producer has little discretion about what
combination of inputs to employ. The only decision is how much to produce.
Production in the short run: production with only one variable input
We begin the analysis of production in the short run with the simplest kind of short-run situation: only

one variable input and one fixed input:

         Total product, average product, and marginal product

         Total product : assume that the input of capital is fixed, then

22
          Average product is the total product (output) divided by the amount of the variable

input. The average product of labor is the total product divided by the number of

workers:

  Marginal product is the additional output attributable to using one additional unit of
input.
         Law of diminishing marginal product is the principle that as the number of the units of the variable
input increases, other inputs held constant, a point will be reached beyond which the marginal
product decreases.

Increasing (Decreasing) causes the total product curve, average product curve, and marginal
product curve to shift upward (downward).

The Nature of Economic Costs

        Opportunity cost: The cost of using resources to produce a good or service is the opportunity
cost to the owners of the firm using those resources. The opportunity cost is what the owners
must give up to use a resource. The opportunity cost of using an input or a resource is classified
as either an explicit cost or an implicit cost.
        An explicit cost is an out-of-pocket monetary payment for the use of a resource. It is an
accounting cost. An explicit cost is the opportunity cost of using resources that are owned by
others.
        An implicit cost is the foregone return the firm’s owners could have received had they used
their own resources in their best alternative use. An implicit cost is the opportunity cost of
using resources that are owned by the owners of the firm.
        Normal profit is the implicit cost of using own-supplied resources.
        Variable costs are costs that will change when output changes. The payments for variable
inputs are variable costs. Examples of variable costs are payments for many types of labor,
ingredient inputs or raw materials, or energy used in production.
         Fixed costs are costs that will not change when output changes. The payments for fixed inputs
are fixed costs. In the short run some inputs are fixed.
        In the long run all costs are variable costs.

23
Chapter 4 : Market Structures

For defining market structure we first need to understand what market is? Market is a place where
buyers and sellers meet and exchange goods or services. And now if we extend this concept a little
more, there are certain conditions which create the structure of a market. Such conditions can be
condensed in the following –

 Number of Buyers
 Number of sellers
 Buyer Entry Barriers
 Seller Entry Barriers
 Size of the firm
 Product Differentiation/ Homogeneous Product
 Market Share
 Competition
The above factors are the quick reference if you need to judge the market structure and under which
one particular firm belongs to.

Classification of Market Structure

As there are lot many factors deciding on the market structure, there are lot many variations as well
determining the particular market structure in the economy. If we try to explore that individually it
might not crystallize our concept.

Thus, let’s look at the following chart to understand the varied market structures –

From the above chart now it’s clear that how the market structure can be defined by the various factors
and their way of exercising certain power over the market. However if we consider the gradual increase
of competition from least to maximum, we will come up to the following conclusions –

1. Monopoly
2. Oligopoly

24
 3. Monopolistic Competition
4. Perfect Competition

Now let’s look at some of the examples of all the market structure mentioned above so that the concept
can dig into your mind and facilitate in your application of market structure –

 Monopoly – Companies which are state owned and entry for other players are not allowed. If
we take example from Indian perspective there is one example we can think of is Indian railway
which is the monopoly as there is no other contributor exercising in the same market.
 Oligopoly – In US and other countries people buy their automobiles from different companies.
Here the buyers are many, sellers are few, and competition is high.
 Monopolistic Competition – Let’s take a common example. Look around your locality. There are
some good numbers of restaurants serving their customers. Though they might be producing same
kind of recipes, the branding would be different. And that’s the catch of monopolistic competition.
Many buyers, many sellers, almost same product but different branding and fierce competition.
 Perfect Competition – Though in concept perfect competition exists, however in real life only
near perfect competition can exist. And the staple food and vegetables we buy from the market is
perfect competition. However when they start branding they move toward oligopoly.
 In case of Monopsony and Oligopsony there are almost no practical examples though they are
just the opposite of monopoly and oligopoly respectively (buyers rule).
How Understanding Market Structure Would Help You?

Before reading this article or prior to studying about market structure we could have underestimated
the value of comprehending different kind of market structure. But after knowing about them now we
can line up with a quite good number of benefits –

 When we know the market structure it helps us understanding a major chunk about a particular
company and which market structure it belongs to. Thus we can measure the market share, forces

25
 operating in the same market structure, its competitors, and line of products and range of
competition.
 When we know about a company it helps us in investment. Whether we should go for putting
our money into the company or not, how risky the investment could be, how much could we lose
and most importantly whether there is any other choice available or not!
 The study of market structure provides us with a vision which could intuitively tell us what
would be the future economy, who would be the market leaders, whose demand would be greater,
whose goods or services might become obsolete in the future and what would be the factors which
would control the whole market?
 It facilitates where we are as a buyer or seller. When we know the market structure, we can
understand in which side we are as of now? We can also understand that there is any barrier to entry
into the market or not, whether there is any influence we can bring into the market place, what kind
of market structure we would belong to and a lot more!
 It gives a general idea about how demand and supply work in a market place and how
consumerism can eat away or benefit our ability to live well. Different types of products/services,
different kinds of buyers and sellers, their different roles and continuous effort to create better
product or to solve a problem would then become more understandable when we acquire the bits
and pieces about structures a particular market follows.
In Conclusion

The importance of market structure in an economy cannot be over emphasized as the effect of market
structure on an economy, it’s development or degradation is recently been realized. Thus we as the part
of the economy need to understand the value of this concept while dealing with others (buyers/sellers)
in any market place to yield the optimum benefit and to create win-win situation for all of us.

26
 Questions on Managerial Economics

1 Define managerial economics with definition.

2 How does managerial economics differ from economics ?

3 Write a short note on managerial economists.

4 Explain the scope of managerial economics.

5 “ Managerial economics is the integration of economic theory with business practice for the purpose of
facilitating decision making and forward planning by management?” Explain.

6 Construct a demand and supply schedule as per the data given below.

Price Demand Supply

15 50 15
20 40 20
25 30 25
30 15 30
35 10 35

7 Explain types of elasticity. What is the link between elasticity and business decision making.

8 Define production function.

9 Explain the difference between explicit and implicit cost.

10 Explain the features of following market structures.

1 Oligopoly

2 Monopolistic Competition

27
28