Economics & Management Decisions

UNIVERSITY OF TOMORROW
Economic and
Management Decisions
Course Design
SLM Development Team

Prof (Dr.) Rajesh Gupta
Dr. Arvind Jain
Dr. Kabir Sharma
Dr. Shantanu Trivedi
Rahul Sharma
Author
Dr. Komal Pancholi
Assistant Professor
PhD, M.Com., NET
Course Code : ECON7034D

Course Name : Economics & Management Decisions
Version : July 2023
@All Right Reserved with CCE UPES

UNIT 20: Case Study
Contents
Unit 1 Introduction to Managerial Economics ......................................................................... 3

Unit 2 A Brief Analysis of Utility ............................................................................................ 13
Unit 3 Laws of Utility ............................................................................................................. 19
Unit 4 Demand Analysis.......................................................................................................... 33
Unit 5 Law of Demand .......................................................................................................................... 47
Unit 6 Elasticity of Demand .................................................................................................................. 55
Unit 7 Demand Forecasting – Concept and Survey Methods........................................................... 67
Unit 8 Statistical Methods of Demand Forecasting ........................................................................... 73
Unit 9 Supply Analysis ........................................................................................................................... 91
Unit 10 Pricing Methods....................................................................................................................................... 179
Unit 11 Break-Even Analysis ................................................................................................................ 207

Unit 12 Decision Making Process......................................................................................................... 215
UNIT 1: Introduction to Managerial Economics
Unit 1
3
Notes
Introduction to Managerial
___________________
___________________
Economics ___________________
___________________
Objectives ___________________
After completion of this unit, the students will be aware of the following
___________________
topics:
___________________
\ Nature and scope of managerial economics
\ Role of economics in decision making ___________________
\ Concepts of economic analysis ___________________
___________________
Introduction
Managerial Economics is a discipline that combines economic
theory with managerial practice. It tries to bridge the gap between
the problems of logic that intrigue economic theorists and the
problems of policy that plague practical managers. The subject
offers powerful tools and techniques for managerial policy making.
An integration of economic theory and tools of decision sciences
works successfully in optimal decision making, in face of
constraints. A study of managerial economics enriches the
analytical skills, helps in the logical structuring of problems, and
provides adequate solution to the economic problems. To quote
Mansfield, “Managerial Economics is concerned with the
application of economic concepts and economic analysis to the
problems of formulating rational managerial decisions.” Spencer
and Siegel man have defined the subject as “the integration of
economic theory with business practice for the purpose of
facilitating decision making and forward planning by
management.”
Nature of Managerial Economics

Contribution of Economic Theory to Managerial Economics
Baumol believes that economic theory is helpful to managers for

three reasons. First, it helps in recognizing managerial problems,
eliminating minor details which might obstruct decision making
and in concentrating on the main issue. A manager is able to
Economics & Management Decisions
4
ascertain the relevant variables and specify relevant data. Second,
Notes
Activity it offers them a set of analytical methods to solve problems.
How___________________
economic theory is helpful
to managers?
Economic concepts like consumer demand, production function,
___________________ economies of scale and marginalize help in analysis of a problem.
Third, it helps in clarity of concepts used in business analysis,
___________________
which avoids conceptual pitfalls by logical structuring of big issues.
___________________
Understanding of inter-relationships between economic variables
___________________ and events provides consistency in business analysis and decisions.
___________________ For example, profit margins may be reduced despite an increase in
sales due to an increase in marginal cost greater than the increase
___________________
in marginal revenue. Ragnar Frisch divided economics in two
___________________ broad categories – macro and micro. Macroeconomics is the study
___________________ of economy as a whole. It deals with questions relating to national
income, unemployment, inflation, fiscal policies and monetary
___________________
policies. Microeconomics is concerned with the study of individuals
like a consumer, a commodity, a market and a producer.
Managerial Economics is micro-economic in nature because it deals

with the study of a firm, which is an individual entity. It analyses
the supply and demand in a market, the pricing of specific input,
the cost structure of individual goods and services and the like.
The macroeconomic conditions of the economy definitely influence
working of the firm, for instance, a recession has an unfavorable
impact on the sales of companies sensitive to business cycles, while
expansion would be beneficial. But Managerial Economics
encompasses variables, concepts and models that constitute micro-
economic theory, as both the manager and the firm where he works
are individual units.
Contribution of Quantitative Techniques to Managerial

Economics
Mathematical Economics and Econometrics are utilized to
construct and estimate decision models useful in determining the
optimal behavior of a firm. The former helps to express economic
theory in the form of equations while the latter applies statistical
techniques and real world data to economic problems. Like,
regression is applied for forecasting and probability theory is used
in risk analysis. In addition to this, economists use various
optimization techniques, such as linear programming, in the study
of behavior of a firm. They have also found it most efficient to
express their models of behavior of firms and consumers in terms
of the symbols and logic of calculus.
5
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
Figure 1.1: Managerial Economics and Related Discipline ___________________
Thus, Managerial Economics deals with the economic principles

and concepts, which constitute ‘Theory of the Firm’. The subject is
a synthesis of economic theory and quantitative techniques to solve
managerial decision problems. It is micro-economic in character.
Further, it is normative since it makes value judgments, that is, it
states what goals a firm should pursue. Figure 1.1 summarizes our
discussion of the principal ways in which Economics relates to
managerial decision making.
Managerial Economics plays an equally important role in the

management of non-business organizations such as government
agencies, hospitals and educational institutions. Regardless of
whether one manages the ABC hospital, Eastman Kodak or
College of Fine Arts, logical managerial decisions can be taken by a
mind trained in economic logic.
Check Your Progress

Fill in the blanks:
1. ................... is a discipline that combines economic
theory with managerial practice.
2. ................... is the study of economy as a whole. It deals
with questions relating to national income,
unemployment, inflation, fiscal policies and monetary
policies.
3. ................... is concerned with the study of individuals
like a consumer, a commodity, a market and a
producer.
6
Scope & Significance of Managerial Economics
Notes
Activity
What are the three basic
___________________ An analysis of scarcity of resources and choice making poses three
questions that arise due to
scarcity of resources?
basic questions:
___________________
1. What to produce and how much to produce?
___________________
2. How to produce?
___________________
___________________
3. For whom to produce?
___________________ A firm applies principles of economics to answer these questions.

The first question relates to what goods and services should be
___________________ produced and in what quantities. Demand theory guides the
___________________
manager in the selection of goods and services for production. It
analyses consumer behavior with regard to:
___________________
1. Type of goods and services they are likely to purchase in the
___________________ current period and in the future,
2. Goods and services which they may stop consuming,
3. Factors influencing the consumption of a particular good or
service, and
4. The effect of a change in these factors on the demand of that
particular good or service.
A detailed study of these aspects of consumer behavior helps the
manager to make product decision. At some particular time, a firm
may decide to launch new goods and services or stop providing a
particular good or service. For example, in 1990s, Videocon group
launched a new company of kitchen appliances. In 1961, Tata
started TCS, while in 1993, the company ceded TOMCO to HLL.
Knowledge of demand elasticity’s helps in setting up of prices in
context of revenue of a firm. Methods of demand forecasting help in
deciding the quantity of a good or service to be produced.
How to produce the goods and services is the second basic question.
It involves selection of inputs and techniques of production.
Decisions are made with regard to the purchase of items ranging
from raw materials to capital equipment. Production and cost
analysis guides a manager in personnel practices such as hiring
and staffing and procurement of inputs. For example, the decision
to automate clerical activities using PC network results in a more
capital-intensive mode of production. Capital budgeting decisions
also constitute an integral part of the second basic question.
Allocation of available capital in long-term investment projects can
be done through project appraisal methods.
Firms’ third basic question relates to segmentation of market. A
firm has to decide for whom it should produce the goods and
services. For example, it has to decide whether to target the
domestic market or the foreign market. Production of a
7
premium good is another example of market segmentation. An
analysis of market structure explains how price and output Notes
decisions are taken under different market forms. Table 1.1 ___________________
depicts the three basic questions and concepts of economics used
to solve them. ___________________
Table 1.1: Basic Questions & Related Concepts ___________________
Basic Questions Related Concepts ___________________

1. What to produce and how Product decision: consumer demand,
___________________
much to produce? demand elasticity’s and demand
forecasting.
___________________
2. How to produce? Input-output decisions: production and
cost analysis and capital budgeting. ___________________
3. For whom to produce? Market segmentation decision. ___________________
Appropriate business decision making with the help of economic ___________________

tools has gained recognition in view of complex business
___________________
environment. Since the macroeconomic environment is dynamic, it
changes over time; managerial decisions have to be reviewed
constantly. In this context, concepts of consumer behavior, demand
elasticities, demand forecasting, production and cost analysis,
market structure analysis and investment planning help in
making prudent decisions.
Check Your Progress

Fill in the blanks:
1. ................... theory guides the manager in the selection of

goods and services for production.
2. Allocation of available capital in long-term investment
projects can be done through ................... methods.
Role of Managerial Economist

Companies like Tata, DCM, HLL and IPCL employ managerial
economists to guide them in making appropriate economic
decisions. A managerial economist makes an assessment of change
in the consumer preferences, input prices, and related variables to
make successful forecasts of their probable effect on the internal
policies of the firm. They inform the management of a change in
the competitive environment in which a firm functions, and
suggest suitable policies for solution of problems like:
1. What product and services should be produced?
2. What inputs and production techniques should be used?

8
Notes 3. How much output should be produced and at what prices
Activity
should it be sold?
What does the managerial
___________________
economist inform the
management about? 4. What are the best sizes and locations of the new plant?
___________________
___________________ 5. When should the equipment be replaced?
___________________ 6. How should the available capital be allocated?

___________________ A managerial economist has to evaluate changes in the
___________________ macroeconomic indicators like national income, population, and
business cycles, and their likely impact on the functioning of the
___________________
firm. He also studies the impact of changes in fiscal policy,
___________________ monetary policy, employment policy and the like on the functioning
of the firm. These topics come under the purview of
___________________
macroeconomics. Therefore, they deserve a separate treatment.
___________________ The scope of managerial economics is restricted to microeconomics.
Check Your Progress

Fill in the blanks:
1. A ........................... makes an assessment of change.

2. A managerial economist has to evaluate changes in
the.......................... indicators.
Economics and Managerial Decision Making

The best way to become acquainted with Managerial Economics is
to come face to face with real world decision problems. Many
companies have applied established principles of Managerial
Economics to improve their profitability. In the past decade, a
number of known companies have experienced successful changes
in the economics of their business by using economic tools and
techniques. Some cases have been discussed here.
Example 1: Reliance Industries has maintained top position in

polymers by building a world-scale plant and upgrading
technology. This has resulted in low operating costs due to
economies of scale. Reliance Petroleum Ltd. registered a net profit
of ` 726 crores on sales of ` 14,308 crores for the six months ended
September 30, 2000. Of these, exports amounted to ` 2,138 crores,
which make RPL India’s largest manufacturer, exporter.
RPL is planning to expand its capacity from 27 to 30 million tonnes

in April 2001 and further to 40.5 million tonnes by April 2002. The
overall economies of scale are in favour of expansion. This
expansion will further consolidate the position of RPL in the sector
and help in warding off rivals. 9
Example 2: Leading multinational players like Samsung, LG, Notes
Sony and Panasonic cornered a large part of Indian consumer ___________________
durables market in the late 1990s. This was possible because
___________________
of global manufacturing facilities and investment in technologies.
To maintain their market share, they resorted to ___________________
product differentiation. These companies introduced ___________________
technologically advanced models with specific product
___________________
features and product styling.
___________________
Example 3: For P&G, the 1990s was a decade of ‘value-oriented’
___________________
consumer. The company formulated policies in view of emergence
of India as ‘value for money’ product market. This means that ___________________
consumers are willing to pay premium price only for quality goods. ___________________
Customers are “becoming more price-sensitive and
___________________
quality conscious…more focused on self satisfaction…” It can,
therefore, be said that consumer preferences and tastes have
come to play a vital role in the survival of companies.
Example 4: In late 1990s, HLL earned supernormal profits

by selling low-priced branded products in the rural areas. This
was a result of market segmentation policy adopted by the
company. The company considers the rural market as a
separate market. It is now developing packages for the rural
market with products, packaging, and pricing tailor made for the
rural consumers.
To ward off rivals and to make it a better competitor the company

resorted to mergers and acquisitions. Merger of BBIL with HLL in
1996 made it the largest conglomerate in the consumer goods
market in India. Over the years HLL has acquired Kissan and
Dipys from UB group; Dollops from Cadburys in 1993; and
International Bestfoods in 2000, to achieve economies of scope.
Example 5: Apple, the company that began the PC revolution, had

always managed to maintain its market share and profitability by
differentiating its products from the IBM PC compatibles.
However, the introduction of Microsoft’s Windows operating
system gave the IBM and IBM compatible PCs the look feel, and
ease of use of the Apple Macintosh. This change in the competitive
environment forced Apple to lower its prices to levels much closer
to IBM compatibles. The result has been an erosion of profit
margins. For example, between 1991 and 1993, Apple’s net profit
margins fell from 5 to 1 per cent. In all the above examples,
decision making has primarily been economic in nature as it
10
involves an act of choice. The decision of Reliance Industries to
Notes build a plant of international scale and to further expand capacity
___________________ was made on the basis of the law of returns to scale and economies
of scale. Similarly, the MNCs in the consumer durables market in
___________________
India emphasized on global manufacturing facilities coupled with
___________________ product differentiation to capture and maintain a major portion of
___________________ market share. It should be noted that scale economies are
sufficient for RPL as it operates under homogenous oligopoly but
___________________
consumer durables market falls under differentiated oligopoly
___________________ market structure, so it requires emphasis on differentiation as
well. Likewise, Apple had always managed to maintain market
___________________
share due to product differentiation.
___________________
Fast moving consumer goods (FMCG) companies, P&G and HLL
___________________
took concepts of consumer demand analysis, namely, consumer
___________________ preferences and market segmentation respectively, to maintain
their dominant position in various product categories. Selection of
product portfolio of P & G is an expression of consumer choice for
quality products. HLL strategy to earn supernormal profits by
catering to rural areas is an economic decision based on selection of
an expanding market segment. The objective of HLL of being the
largest firm in the industry was achieved by economies of scope
acquired through mergers and acquisitions.
Check Your Progress

Fill in the blanks:
1. Many companies have applied established principles of
Managerial Economics to improve their ……………….. .
2. The best way to become acquainted with Managerial
Economics is to come face to face with real world
.............................
Summary
Managerial Economics is a discipline that combines economic
theory with managerial practice. It is micro-economic in nature
because it deals with the study of a firm, which is an individual
entity. It encompasses variables, concepts and models that
constitute micro-economic theory. Mathematical Economics and
Econometrics are utilized to construct and estimate decision
models useful in determining the optimal behavior of a firm. An
analysis of scarcity of resources and choice making poses three
basic questions, i.e., what to produce and how much to produce?
How to produce? For whom to produce? A managerial economist
has to evaluate changes in the macroeconomic indicators like
national income, population, and business cycles, and their likely 11
impact on the functioning of the firm. He also studies the impact of Notes
changes in fiscal policy, monetary policy, employment policy and
___________________
the like on the functioning of the firm. The essence of
economic science is determination of optimal behavior which is ___________________
subject to constraints arising basically due to scarcity of ___________________
resources. Constraints are so pervasive and important that
___________________
economists use the term “constrained optimization” synonymous
to maximization. ___________________
___________________
Lesson End Activity ___________________
Visit an organisation and try to collect the last information
___________________
provided by the managerial economist of that organisation.
___________________
Keywords ___________________
Firm: It is an organization that combines and organizes resources

for the purpose of producing goods and/or services for sale.
Long Run: It refers to a time period sufficient enough to vary all

inputs used in production of a good or service.
Macroeconomics: It is the study of economy as a whole. It deals

with questions relating to national income, unemployment,
inflation, fiscal policies and monetary policies.
Microeconomics: It is concerned with the study of individuals like

a consumer, a commodity, a market and a producer.
Opportunity Cost: This is the amount of subjective value foregone

in choosing one alternative over the next best alternative. It is the
‘cost of sacrificed alternatives’.
Scarcity: It can be defined as a condition in which resources are

not available in adequate amount to satisfy all the needs and
wants of a specified group of people.
Short Run Costs: These are the costs incurred on the variable
inputs in the short run.
Questions for Discussion
1. Define managerial economics with definition.
2. How does managerial economics differ from economics?
3. Write a short note on managerial economist.

12
Notes 4. Explain the scope of managerial economics.
___________________ 5. Explain the role and responsibilities of managerial economist.

___________________
Further Readings
___________________
___________________ Books
___________________
Managerial Economic by Christopher R Thomas, S Charles
___________________ Maurice – Special Indian, 8th Ed, Mc-Graw Hill Education.
___________________ Managerial Economics by Atmanand, 2nd Edition, Excel Books
___________________ Publication
___________________ Managerial Economics by Karampal and Surender Kumar, 1st

Edition. Excel Books Publication.
___________________
Web Readings
en.wikipedia.org/wiki/Managerial_economics
www.swlearning.com/economics/hirschey/managerial.../chap01.pdf
www.booksites.net/download/davieslam/download.../Chapter1.ppt
UNIT 2: A Brief Analysis of Utility
Unit 2
13
Notes
A Brief Analysis of Utility

___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Meaning of utility ___________________

\ Total Utility ___________________
\ Marginal Utility
___________________
___________________
Introduction
___________________
Generally, we know that our needs are unlimited and we require or
demand products/commodities to satisfy needs as products which
are of “bundle of utilities”. In other words, consumers demand a
commodity because they derive or expect to derive utility from that
commodity. The expected utility from a commodity is the basis of
demand for it.
Meaning of Utility
The term ‘utility’ is commonly used term, but it has a specific
meaning and use in the analysis of consumer demand or consumer
behaviour in terms of cardinal analysis. The concept of utility can
be looked upon from two angles: the commodity angle and the
consumers’ angle. At first sight, utility is the want-satisfying
property of a commodity. And at the other, utility is the
psychological feeling of satisfaction; pleasure, happiness or well-
being which a consumer derives from the consumption, possession
or the use of a commodity. There is a disparity between these two
concepts, which must be kept in mind. The concept of a want-
satisfying property of a commodity is ‘absolute’ in the sense that
this property is inbuilt in the commodity irrespective of whether
one needs it or not. For instance, a pen has its own utility of
writing irrespective of whether a person is literate or illiterate.
Another important feature of the ‘absolute’ concept of utility is that
it is ‘ethical neutral’ because a commodity may satisfy socially
immoral needs, for example alcohol. Contrary to the consumer’s
point of view, utility is supposed as a post-consumption
14 phenomenon as one derives satisfaction from a commodity only

Notes
Activity when one consumes or uses it.
What is the want-satisfying
___________________
property of a commodity?
Utility in terms of satisfaction is a subjective or relative concept
___________________ because (i) a commodity need not be useful for all. For instance,
___________________ cigarettes do not have any utility for non-smokers and meat has no
utility for pure vegetarians; (ii) utility of a commodity varies from
___________________
person to person and from time to time; and (iii) a commodity need
___________________ not have the same utility for the same consumer at different points
___________________ of times, at different levels of consumption and at different moods
of a consumer. In consumer analysis, only the ‘subjective’ concept
___________________
of utility is used.
___________________
In economics, utility is a representation of preferences over some
___________________
set of goods and services. Preferences have a (continuous) utility
___________________ representation so long as they are transitive, complete, and
continuous.
Utility is usually applied by economists in such constructs as
the indifference curve, which plot the combination of commodities
that an individual or a society would accept to maintain a given
level of satisfaction. Individual utility and social utility can be
construed as the value of a utility function and a social welfare
function respectively. When coupled with production or commodity
constraints, under some assumptions, these functions can be used
to analyze Pareto efficiency, such as illustrated by Edgeworth
boxes in contract curves. Such efficiency is a central concept
in welfare economics.
In finance, utility is applied to generate an individual's price for
an asset called the indifference price. Utility functions are also
related to risk measures, with the most common example being
the entropic risk measure.
Quantifying Utility
It was recognized that utility could not be measured or observed
directly, so instead economists devised a way to infer underlying
relative utilities from observed choice. These 'revealed preferences',
as they were named by Paul Samuelson, were revealed e.g. in
people's willingness to pay:
Utility is taken to be correlative to Desire or Want. It has been
already argued that desires cannot be measured directly, but only
indirectly, by the outward phenomena to which they give rise: and
that in those cases with which economics is chiefly concerned the 15
measure is found in the price which a person is willing to pay Notes
Activity
for the fulfilment or satisfaction of his desire. Who___________________
named utility as revealed
preferences?
For example, suppose a consumer's consumption set is X = ___________________
{nothing, 1 apple,1 orange, 1 apple and 1 orange, 2 apples, 2
___________________
oranges}, and its utility function is u (nothing) = 0, u (1 apple) = 1,
u (1 orange) = 2, u (1 apple and 1 orange) = 4, u (2 apples) = 2 and ___________________
u (2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, ___________________

but prefers one of each to 2 oranges. ___________________
Check Your Progress ___________________
Fill in the blanks: ___________________
1. ...................is a representation of preferences over some ___________________
set of goods and services. ___________________
2. Contrary to the consumer’s point of view, utility is

supposed as a ................... phenomenon.
Total Utility
Assuming that utility is measurable and additive, total utility may
be defined as the sum of the utilities derived by a consumer from
the various units of goods and services he consumes. Suppose a
consumer consumes four units of a commodity, X, at a time and
derives utility as u1, u2, u3 and u4. His total utility from commodity
X (TUx) can be measured as follows.
TUx = u1+u2+u3+u4
If a consumer consumes n number of commodities, his total utility,

TUn, will be the sum of total utilities derived form each commodity.
For example, if the consumed goods are X, Y and Z and their total
respective utilities are Ux, Uy, and Uz, then
TUn = Ux+Uy+Uz
Check Your Progress

Fill in the blanks:
1. ................... may be defined as the sum of the utilities
derived by a consumer from the various units of goods
and services he consumes.
2. TU is the abbreviation for ....................
16
Marginal Utility
Notes
Activity
How___________________
can MU be expressed? Marginal utility is another most important concept used in
economic analysis. Marginal utility may be defined as the utility
___________________
derived from the marginal unit consumed. It may also be defined
___________________
as the addition to the total utility resulting from the consumption
___________________ of one additional unit. Marginal Utility (MU) thus refers to the
___________________ change in the Total Utility (DTU) obtained from the consumption
of an additional unit of a commodity. It may be expressed as
___________________
___________________
MU = DTU/DQ
___________________ Where TU = total utility, and DQ = change in quantity consumed

by one unit.
___________________
___________________ Another way of expressing marginal utility (MU), when the

number of units consumed is n, can be as follows:
MU of nth unit = TUn – TUn-1
Check Your Progress

Fill in the blanks:
1. ................... may be defined as the utility derived from
the marginal unit consumed.
2. MU is the abbreviation for ....................
Summary
An individual demands commodities due to their utility and utility
is the want-satisfying property of a commodity. In addition, it is
the psychological feeling of satisfaction; pleasure, happiness or well
being which a consumer derives from the consumption, possession
or the use of a commodity. Further, the demand for goods in terms
of quantity is based upon their MU. If the marketers increase MU
in terms of reuse of the product, reduction in price, change in the
design of the product etc.; than they may create the demand for the
same commodities.
Lesson End Activity

Derive the TU and the MU curve with the help of the explanation
given in this unit.
Keywords 17
Notes
Marginal Utility: The addition to the total utility resulting
from the consumption of one additional unit. ___________________
___________________
Total Utility: The sum of the utilities derived by a consumer
from the various units of goods and services he consumes. ___________________
Utility: Utility is the want-satisfying property of a commodity. ___________________
___________________
Questions for Discussion ___________________
___________________
1. What do you mean by utility and the concept of cardinal
utility? ___________________
2. Define the concept of total utility. ___________________
3. What is the meaning of marginal utility? ___________________
4. Explain whether utility is quantifiable. Give reasons.

5. Distinguish between the concepts of TU and MU.
Further Readings
Books
Salvatore, Dominick: Managerial Economics in a Global Economy,
4th ed. (Singapore: South-Western, 2001).
Dornbusch, R., Stanley Fisher and Richard Startz (2001),

Microeconomics, New Delhi: Tata McGraw-Hill.
Petersen, H. Craig and Lewis, W. Cris (2001), Managerial

Economics, Pearson Education Asia, New Delhi-110092.
Koutsoyanis, A, Modern Microeconomics (1979), (Macmillan

Publishing Company, New York).
Boulding, K. E., (1966) Economics Analysis: Microeconomics, Vol. I,

4th ed., (New York, Harper and Row).
Web Readings
en.wikipedia.org/wiki/Marginal_utility
www.britannica.com/EBchecked/topic/364750/marginal-utility
18
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 3: Laws of Utility
Unit 3
19
Notes
Laws of Utility
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Law of diminishing marginal utility ___________________

\ Equi-marginal concept ___________________
\ Law of Equi-marginal utility
___________________
___________________
Introduction
___________________
Economists use the word utility to describe the ability of a good or
service to satisfy some want we possess. A donut has utility if it
can satisfy our hunger; a movie has utility if it satisfies our desire
for entertainment. Economists also recognize that the ability of a
product to satisfy our want or need may diminish the more
frequently it is consumed. The first donut you buy may do a great
job of satisfying your hunger, the second may as well. But the third
may be less satisfying to you, and you may be totally uninterested
in the fourth. The once invaluable donut has lost much of its
seductive appeal. We might call this the law of diminishing
seductive appeal. But economists are a stodgy bunch, so they call
this the law of diminishing marginal utility.
Now given our law of demand, we realize that if the donut vendor
cuts his price, we may recover some interest. At half price, we
might muscle-up for one more 417 calorie chocolate covered
cholesterol enhancing treat. But even at a reduced price, utility
will eventually diminish until prices drop again and then again
and again.
The laws of demand and diminishing marginal utility combine to
produce demand curves that predictably flow downward from left
to right. The actual market price for a good may change, and that
will trigger a change in the number of units sold, but the
relationship between demand and price will remain constant—
prices and demand will shift in sync with one another along the
demand curve.
20
Economists refer to this sliding along the demand curve as
Notes
Activity
movement. Movement occurs when changes in the market price for
What does the downward
___________________
sloping MU curve illustrate? a good causes demand to slide up or down the curve—or when a
___________________ change in the demand causes prices to slide up or down the curve.
___________________ But economists also recognize the existence of certain factors that
___________________ will cause the entire curve to shift—move either to the left or the
right. Changes in income, consumer tastes or preferences, and in
___________________
the price of substitution goods and complementary goods will
___________________ prompt not just movement along the curve but a shift of the curve
___________________ in one direction or the other.
___________________
___________________
The Law of Diminishing Marginal Utility
___________________ The law of diminishing marginal utility is one of the fundamental
laws of economics. It states, as the quantity consumed of a
commodity increases, the utility derived from each successive unit
decreases, remaining the same consumption of all other
commodities. In simple words, when a person consumes more and
more units of a commodity per unit of time, example, ice cream,
keeping the consumption of all other commodities constant, the
utility which he derives from the successive units of consumption
goes on diminishing. This law applies to all kinds of consumer
goods-durable and non-durable sooner or later. Let us assume that
utility is measurable in quantitative terms and illustrate the law
of diminishing marginal utility. The law of diminishing marginal
utility is illustrated numerically in Table 3.1.
Table 3.1: Total and Marginal Utility Schedules
No. of units Total Utility Marginal Utility

1 30 30
2 50 20
3 60 10
4 65 5
5 60 -5
6 45 -15
As shown in Table 3.1, with the increase in the number of units

consumed per unit of time, the TU increases but at a diminishing
rate. The diminishing MU is shown in the last column.
21
The rate of increase in TU as the result of increase in the number
of units consumed is shown by the MU curve in Table 3.1. The Notes
downward sloping MU curve shows that marginal utility goes on ___________________

decreasing as consumption increases: After four units ___________________
consumption, the TU reaches its maximum level, the point of
___________________
saturation, and MU becomes zero. Beyond this, MU becomes
negative and TU begins to decline. The downward sloping MU ___________________
curve illustrates the law of diminishing marginal utility. ___________________
Why does the MU Decrease? ___________________
___________________
The utility gained from a unit of a commodity depends on the
intensity of the desire for it. When a person consumes successive ___________________
units of a commodity, his need is satisfied by degrees in the ___________________

process of consumption and the intensity of his need goes on ___________________
decreasing: Therefore, the utility obtained from each successive
unit goes on decreasing.
Assumptions: The law of diminishing marginal utility holds only

under certain conditions. These conditions are referred to as
the assumptions of the law. The assumptions of the
law of diminishing marginal utility are: (i) the unit of the
consumer good must be a standard one, such as a cup of tea,
a bottle of cold drink, a pair of shoes or trousers. If the
units are excessively small or large the law may not hold; (ii)
the consumer’s taste or preference must remain the same
during the period of consumption; (iii) there must be
continuity in consumption. Where a break in continuity is
necessary, the time interval between the consumption of
two units must be appropriately short; and (iv) the mental
condition of the consumer must remain normal during the period
of consumption.
Given these conditions, the law of diminishing marginal utility

holds universally. In some cases, such as accumulation of money,
collection of hobby items like stamps, old coins, rare paintings and
books and melodious songs. The marginal utility may initially
increase rather than decrease. But eventually it does decrease. As
a matter of fact, the law of marginal utility generally operates
universally.
22
Check Your Progress
Notes
Activity
What is the ordinal concept of Fill in the blanks:
___________________
utility?
___________________
1. The law of ...................................... is one of the
fundamental laws of economics.
___________________
2. In simple words, when a person consumes more and
___________________
more units of a commodity per unit of time, keeping the
___________________ consumption of all other commodities constant, the
___________________ utility which he derives from the successive units of
consumption goes on ....................
___________________
___________________ Cardinal and Ordinal Concepts of Utility

___________________
Utility is a psychological phenomenon. It is a feeling of
___________________ satisfaction, pleasure or happiness. Measurability of utility has,
however, been a controversial issue. The classical economists
Jeremy Bentham, Leon Walrus and Carl Menger and neo-classical
economist, notably Alfred Marshall believed that utility is
cardinally or quantitatively measurable like height, weight, length,
temperature, and air pressure. This belief resulted in the Cardinal
Utility concept. The modern economists J.R. Hicks and R. G. D.
Allen, however, hold the view that utility is not quantitatively
measurable-it is not measurable in absolute terms. Utility can be
expressed only ordinally, relatively or in terms of less than or more
than. It is, therefore, possible to list the goods and services in order
of their preferences or desirability. This is known as the ordinal
concept of utility.
Cardinal Utility
The concept of cardinal utility implies that utility can be assigned
a cardinal number like 1, 2, 3, etc. the Neo-classical economists
built up the theory of consumption on the assumption that utility
is cardinally measurable. They used a term “util” meaning ‘units of
utility’. In their economic analysis, they assumed (i) that one ‘util’
equals one unit of money, and (ii) that utility of money remains
constant. It has, however, been realized over time that absolute or
cardinal measurement of utility is not possible. Difficulties in
measuring utility have proved to be impossible. Neither economists
nor scientists have succeeded in devising a technique or an
instrument for measuring the feeling of satisfaction, that is, utility.
Nor could an appropriate measure of unit be devised. Numerous
factors affect the state of consumer’s mood, which are impossible to
determine and quantify. Utility is therefore immeasurable 23
in cardinal terms. Notes
Approaches to Consumer Demand Analysis ___________________
___________________
There are two approaches to the analysis of consumer behaviour.
___________________
1. Cardinal Utility Approach: attributed to Alfred Marshall ___________________
and his followers, is also called the Neo-classical Approach.
___________________
2. Ordinal Utility Approach: pioneered by J. R. Hicks, a Nobel
___________________
laureate and R. G. D. Allen, is also called the Indifference
___________________
Curve Analysis.
___________________
The two approaches are not in conflict with one another. In fact,
___________________
they represent two levels of superiority in the analysis of consumer
behaviour. Both the approaches are important for managerial ___________________
decisions depending on the level of superiority required. It is
important to note in this regard that in spite of tremendous
developments in consumption theory based on ordinal utility, the
classical demand theory based on cardinal utility has retained its
appeal and applicability to the analysis of market behaviour.
Besides, the study of classical demand theory serves as a
foundation for understanding the advanced theories of consumer
behaviour. The study of classical theory of demand is of particular
importance and contributes a great deal in managerial decisions.
In the following sections, we will discuss the theory of consumer

behaviour based on the cardinal utility approach.
Analysis of Consumer Behaviour: Cardinal Utility Approach
The central theme of the consumption theory is the utility

maximizing behaviour of the consumer. The fundamental postulate
of the consumption theory is that all the consumers: individuals
and households aim at utility maximization and all their decisions
and actions as consumers are directed towards utility
maximization. The cardinal utility approach to consumer analysis
makes the following assumptions.
1. Consumer is rational: It is assumed that the consumer is a

rational being in the sense that he satisfies his wants in the
order of their preference. That is, he or she buys that
commodity first which yields the highest utility and that last
which gives the least utility.
24
2. Limited income: The consumer has a limited income to
Notes
spend on the goods and services he or she chooses to consume.
___________________ Limitedness of income, along with utility maximization
___________________ objective makes the choice between goods inevitable.
___________________ 3. Maximisation of satisfaction: Every rational consumer

___________________ intends to maximize his/her satisfaction from his/her given
money income.
___________________
___________________ 4. Utility is cardinally measurable: The cardinalists have

assumed that utility is cardinally measurable and that utility
___________________
of one unit of a commodity equals the money which a
___________________ consumer is ready to pay for it or 1 unit = 1 unit of money.
___________________
5. Diminishing marginal utility: It is assumed that the
___________________ utility gained from the successive units of a commodity
consumed decreases as a consumer consumes larger quantity
of the commodity.
6. Constant marginal utility of money: The cardinal utility

approach assumes that marginal utility of money remains
constant whatever the level of a consumer’s income. This
assumption is necessary to keep the scale of measuring rod of
utility fixed. It is important to recall in this regard that
cardinalists used money as a measure of utility.
7. Utility is additive: Cardinalists assumed not only that

utility is cardinally measurable but also that utility derived
from various goods and services consumed by a consumer can
be added together to obtain the total utility. In other words,
the consumer has a utility function, which may be expressed
as:
U = f(X1, X2, X3, Xn), where X1, X2, X3, Xn denote the total
quantities of the various goods consumed.
Given the utility function, total utility obtained form n items

can be expressed as: Un = U1(X1) + U2(X2) + U3(X3) + ... + Un(Xn)
It is this utility function, which the consumer aims to

maximize.
Consumer’s Equilibrium
Conceptually, a consumer is said to have reached his equilibrium
position when he has maximized the level of his satisfaction, given
his resources and other conditions. Technically, a utility- 25
maximizing consumer reaches his equilibrium position when
Notes
allocation of his expenditure is such that the last penny spent on
each commodity yields the same utility. How does a consumer ___________________
reach this position? We know from assumptions 2 and 5, that the ___________________
consumer has limited income and that the utility, which he
___________________
derives from various commodities, is subject to diminishing
returns. Some commodities yield a higher marginal utility and ___________________
some lower for the same number of units consumed. In some ___________________
cases, MU decreases more rapidly than in case of others for the
___________________
same number of units consumed. A rational and utility-
maximizing consumer consumes commodities in the order of ___________________
their utilities. He first picks up the commodity, which yields ___________________
the highest utility followed by the commodity yielding the
___________________
second highest utility and so on. He switches his
expenditure from one commodity to the other in accordance ___________________
with their marginal utilities. He continues to switch his
expenditure from one commodity to another till he reaches a stage
where MU of each commodity is the same per unit of expenditure.
This is the state of consumer’s equilibrium.
1. Consumer’s Equilibrium: One-Commodity Model: Let us

first illustrate consumer’s equilibrium in a simple one-
commodity model. Suppose that a consumer with certain
money income consumes only one commodity, X. Since both
his money income and commodity X have utility) for him, he
can either spend his income on commodity X or retain it in the
form of asset. If the marginal utility of commodity X, (MUx), is
greater than marginal utility of money (MUm) as an asset, a
utility-maximizing consumer will exchange his money income for
the commodity. By assumption, MUx is subject to
diminishing returns (assumption 5), whereas marginal utility of
money (MUm) as an asset remains constant (assumption 6).
Therefore, the consumer will exchange his money income on
commodity X so long as MUx > Px(MUm), Px being the price of
commodity X and MUm = 1 (constant). The utility- maximizing
consumer reaches his equilibrium, i.e., the level of maximum
satisfaction, where
MUx = Px(MUm)
Alternatively, the consumer reaches equilibrium point where,

MUm = 1
Consumer’s equilibrium in a single commodity model is

graphically illustrated in Figure 3.1 as follows.
26
Notes Y
___________________
___________________
Px
___________________
___________________
K MUm
___________________
___________________
MU
&
___________________
Price
___________________
___________________ O Px (MUm )
___________________ Qx
Figure 3.1: Consumer’s Equilibrium in a Single Commudity Model
The horizontal line Px(MUm) shows the constant utility of

money weighted by the price of commodity X (i.e. Px) and MUx
curve represents the diminishing marginal utility of
commodity X. The Px(MUm) line and MUx curve intersect each
other at point E. Point E indicates that at quantity OQx
consumed, MUx= Px(MUm), Therefore, the consumer is in
equilibrium at point E. At any point beyond E, MUx> Px(MUm).
Therefore, if the consumer exchanges his money for
commodity X, he will increase his total satisfaction because
his gain in terms of MUx is greater than his loss in terms of
MUm, This conditions exists till he reaches point E. And, at
Quantity any point below E, MUx < Px(MUm). Therefore, if he
consumes more than OQx, he loses more utility than he gains.
He is therefore a net loser. The consumer can, therefore,
increase his satisfaction by reducing his consumption. This
means that at any point other than E, consumer’s total
satisfaction is less than maximum satisfaction. Therefore,
point E is the point of equilibrium.
2. Consumer’s Equilibrium with Multiple-commodity

Model or the Law of Equi-marginal Utility: In real life,
however, a consumer consumes multiple numbers of goods
and services. So the question arises: How does a consumer
consuming multiple goods reach his equilibrium? The law of
Equi-marginal utility explains the consumer’s equilibrium in
a multi-commodity model. This law states that a consumer 27
consumes various goods in such quantities that the MU Notes
derived per unit of expenditure on each good is the same. In ___________________
other words, a rational consumer spends his income on
___________________
various goods in such a manner that each rupee spent on each
good yields the same MU. Let us now explain consumer’s ___________________
equilibrium in a multi-commodity model. Here, we will ___________________
consider only a two-commodity case. Suppose that a consumer
consumes only two commodities, X and Y, their prices being ___________________
Px and Py, respectively. Following the equilibrium rule of the ___________________

single commodity case, the consumer will distribute his
___________________
income between commodities X and Y, so that
___________________
Y ___________________
___________________
K e e’ MUm
MUx MUy
Px Py
MUx MUy
Px Py
O X
X Y
Figure 3.2: Units of X and Y Commodities
Consumer’s Equilibrium in case of Multiple Commodities

MUx = Px(MUm) and MUy = Py(MUm)
Given these conditions, the consumer is in equilibrium where

MUx/ Px(MUm) =1= MUy/ Py(MUm). ...(2.1)
Since, according to assumption (6), MU of each unit of money (or

each rupee) is constant at I, Equation (2.1) can be rewritten as
MUx/ Px = MUy/ Py = MUm ... (2.2)
MUx/ MUy = Px/ Py ... (2.3)
Equation (2.2) leads to the conclusion that the consumer reaches

his equilibrium when the marginal utility derived from each rupee
spent on the two commodities X and Y is the same. The two-
28
commodity case can be used to generalize the rule for consumer’s
Notes
Activity equilibrium for a consumer consuming a, large number of goods
How___________________
will a consumer seeking and services with a given income and at different prices.
maximum utility from the Supposing, a consumer consumes A to Z goods and services, his
consumption basket allocate
___________________
the consumption budget on equilibrium condition may be expressed as
goods and services?
___________________
MUA / PA = MUB / PB =… …= MUZ / PZ = MUm ...(2.4)
___________________
Equation (2.4) gives the Law of Equi-marginal Utility.
___________________
It is important to note that, in order to achieve his equilibrium,
___________________
what a utility maximizing consumer intends to equalize is not the
___________________ marginal utility of each commodity he consumes, but the marginal
___________________
utility per unit of his money expenditure on various goods and
services.
___________________
___________________
Check Your Progress
Fill in the blanks:
1. The study of ................... serves as a foundation for
understanding the advanced theories of consumer
behaviour.
2. Every rational consumer intends to ................. his/her
satisfaction from his/her given money income.
The Equi-marginal Concept

The principle of equi-marginalism states that resources should be
allocated or hired in such a way that the ratio of marginal costs of
various uses of a given resource or of various resources in a given
use is the same. For example, such that:
MU/MC1= MU2/MC2=….MUn/MCn
Where,
MU1= marginal utility from good 1, MC1 = marginal cost of good 1,
and so on.
Similarly, a producer seeking maximum profit would use that

technique of production (input-mix), which ensure
MRP1/MC1= MRP2/MC2=….MRPn/MCn
Where,
MRP1 = maximum revenue product of impact for example, labor,
MC1 = marginal cost of input, and so on.
If the preceding equations were not true, utility/profit can be 29
increased by reshuffling resources/inputs. Notes
For example, ___________________
___________________
If MU1/MC1 > MU2/MC2
___________________
As a result, the consumer must buy more of goods 1 and less
___________________
of goods 2 to increase utility.
___________________
The essence of Equi-marginal principle is that
___________________
purchases, activities, or productive resources should be
___________________
allocated so that the marginal utilities, benefits, or value-
added accruing from each purchase, activity or productive ___________________
resources are identical in all uses. ___________________
Example ___________________
A multi commodity consumer wishes to purchase successive utility

of A, B and C. Each unit cost the same and the consumer is
determined to have combination including all the three items.
However, due to budget constraint, the consumer cannot buy more
than six units in all.
The consumer wants the less of it.
To maximize utility, the consumer will end up with a purchase

of 3A + 2B + 1C because that combination satisfies equi-
marginalism.
MUa = MUb = MUc = 8
Units Marginal Utilities
Item A Item B Item C
1 10 9 8
2 9 8 7
3 8 7 6
4 7 6 5
5 6 5 4
6 5 4 3
Often the equi-marginalism concept has to be replaced by equi-

incrementalism. However, the decision rule or optimizing principle
will remain the same.
30
Check Your Progress
Notes
Fill in the blanks:
___________________
___________________
1. The principle of ................... states that resources
should be allocated or hired in such a way that the ratio
___________________
of marginal costs of various uses of a given resource or
___________________ of various resources in a given use is the same.
___________________ 2. MRP is the abbreviation for ................... maximum
___________________ revenue product.
___________________
___________________
Summary
___________________ The law of diminishing utility explains how increasing supply
means decreasing utility per unit of supply. Initial utility is the
___________________
utility of the first unit; marginal utility, the potential utility of a
unit not possessed; total utility, that of all the units. The law of
diminishing utility applies to money as to other commodities.
Keywords
Cardinal Utility: The concept of cardinal utility implies that
utility can be assigned a cardinal number like 1, 2, 3, etc.
Consumer Equilibrium: A consumer is said to have reached his
equilibrium position when he has maximized the level of his
satisfaction, given his resources and other conditions.
Diminishing Marginal Utility: The quantity consumed of a
commodity increases, the utility derived from each successive unit
decreases, remaining the same consumption of all other
commodities.
Rationality: Rational being in the sense that consumer satisfies
his wants in the order of their preference.

1. What do you mean by the concept of cardinal utility?
2. Define the law of diminishing marginal utility.
3. What is the meaning of consumer equilibrium with reference

to cardinal approach?
4. Define the marginal rate of substitution. What is the law
behind the diminishing marginal rate of substitution?
Further Readings 31
Notes
Books
___________________
Salvatore, Dominick: Managerial Economics in a Global
___________________
Economy, 4th ed. (Singapore: South-Western, 2001).
___________________
Dornbusch, R., Stanley Fisher and Richard Startz (2001),
Microeconomics, New Delhi : Tata McGraw-Hill. ___________________
___________________
Petersen, H. Craig and Lewis, W. Cris (2001), Managerial
Economics, Pearson Education Asia, New Delhi-110092. ___________________
Koutsoyanis, A, Modern Microeconomics (1979), (Macmillan ___________________

Publishing Company, New York).
___________________
Boulding, K. E., (1966) Economics Analysis: Microeconomics, Vol. I, ___________________
4th ed., (New York, Harper and Row).
___________________
Web Readings
en.wikipedia.org/wiki/Marginal_utility
www.britannica.com/EBchecked/topic/364750/marginal-utility
32
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 4: Demand Analysis
Unit 4
33
Notes
Demand Analysis
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Demand concepts ___________________

\ Exemplify their use ___________________
\ Demand Function
___________________
\ Factors influencing the demand of a consumer
___________________
___________________
Introduction
Companies across the world acknowledge that consumer demand
plays a significant role in the creation and survival of a firm. In the
initial stage, sufficient demand for a good or service is essential for
setting up of a firm. Later, the success or failure of a business
depends mainly on its ability to generate revenues by satisfying
consumer preferences. Greater the customer satisfaction more will
be the market share and profitability of the firm. As a result, most
companies generally introduce a change in the product-mix and
service-mix with a change in customer requirements and
expectations. Therefore, it can be said that, the customer is the
pivot around whom the modern business revolves.
Concept of Demand
The demand for a good or service refers to the quantity that people
are ready to buy at various prices within some given time period,
other factors held constant. It is always defined with reference to a
price, a particular time, a place and given values of variables.
Demand can also be called as the desire for the product backed by
willingness and ability to pay for it. The desire to own a computer
but inability to pay for it is not regarded as demand. Similarly, the
desire of a miser to own a car is not demand as he is not willing to
pay for it, despite affordability. And above all there should be a
desire for a good or service. Therefore, a want becomes effective
demand when there is:
z Desire to buy,
34
z Ability to pay, and
Notes
Activity
Give an example for demand.
z Willingness to pay.
___________________
___________________ Check Your Progress

___________________ Fill in the blanks:
___________________ 1. The demand for a good or service refers to the

.................. that people are ready to buy at various
___________________
prices within some given time period.
___________________
2. Demand can also be called as the .................. for the
___________________
product backed by willingness and ability to pay for it.
___________________
___________________ Demand Function

___________________ There are numerous factors that influence the demand for a
product. Therefore, it is difficult to build an exhaustive list. Major
factors influencing demand are the price of the product (Px),
purchasing power or income of the consumer (Py), preferences and
tastes of consumers (Pt), price of related goods (Pr), promotional
activities (Pa), prime population (Pp) and price expectation (Pe).
Thus, we can say that in general, there are seven P's that influence
the demand for a product. These demand determinants can be
presented in form of a demand function.
A demand function is a comprehensive formulation in an equation

form, which specifies the major factors that influence the demand
for a product. Equation 3.1 is such a function which shows the
factors influencing the demand, say for good x (Dx), per time
period.
Dx = f (Px, Py, Pt, Pr, Pa, Pp, Pe, U) ...(4.1)
U refers to the specific factors that influence the demand for a good
or service. Figure 4.1 depicts general and specific factors
influencing demand.
35
Notes
Activity
List___________________
the major factors
influencing demand.
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
Figure 4.1: Factors Influencing Consumer Demand
We will discuss the major factors that influence demand for a good
or service.
1. Price of the Product: Other factors remaining constant, the

demand or sale of a product is inversely related to its price
(own price of the good or service). It implies that, when the
price rises, the quantity demanded or sold decreases and when
the price falls, the quantity demanded or sold increases.
2. Purchasing Power (Income) of the Consumer: The

quantity demanded usually increases with an increase in
income or purchasing power of the consumer. This is so in
case of normal or superior goods like refrigerators, education
and housing. However, there are some goods and services
which are consumed less with an increase in income. These
goods are known as inferior goods, like bajra, hamburgers and
potatoes. The consumer decreases their consumption since he
can now afford to purchase goods of better quality. A
knowledge of relation of the good produced by the firm to the
income of the consumer helps in estimation of current and
future demand.
3. Preferences and Tastes of the Consumer: Goods and

services in fashion have more demand than goods that are out
36
of fashion. Consumer may purchase a good which is popular
Notes and discard the old one. Like in many homes, interiors are
___________________ changed with a change in fashion trends. Various trends in
the past two decades have supported growth in demand for
___________________
new foods (low calorie food, fast food and diet food), new
___________________ electronic products (computer, CDs and Laptops) and new
___________________ recreation services (video parlours, bowling alleys and bungee
jumping).
___________________
___________________
Socio-cultural factors like customs and religious practices
determine the preferences and tastes of the consumer. For
___________________
instance, in India, demand for non-vegetarian food decreases
___________________ during Navratras.
___________________ 4. Price of Related Goods: When goods are substitutes, a fall
___________________ in price of one leads to a fall in quantity demanded of its
substitutes and vice versa. For example, ink pen and ball pen
and different brands of a good (like various brands of soaps
and cars). Curve Ds in Figure 4.2 shows that a significant
increase in price of Zen may lead to an increase in demand of
Santro.
Complementary goods are often consumed simultaneously, for

example, tea and sugar and car and petrol. A pair of goods is
complementary if an increase in price of one leads to a
decrease in demand for the other. Other things remaining
constant a fall in price of cars will increase the demand for
petrol. Curve Dc in Figure 4.2 shows this relationship.
Substitute Goods Complementary goods
DS
Price of Price
Zen of cars
DC
O O
Demand for Santro Demand for petrol
Figure 4.2: Price of Related Goods and Demand
5. Promotional Activities: Advertising and promotional

campaigns have a profound impact on consumer tastes and
preferences. It has been observed that demand for a good
increase with an increase in after sales service, pre sales
service, demonstrations, advertisements and other related
activities.
37
6. Prime Population: The segment of population which Notes
consumes a particular good or service is called as prime
___________________
population. A growth in the prime group has a favorable
___________________
influence on demand. But demographic changes affect demand
over a long period of time. ___________________
___________________
7. Price Expectation: Future expectations of an increase
(decrease) in the price of a good or service may cause current ___________________
demand to increase (decrease). In markets for financial ___________________

instruments (example stocks, shares, bonds, treasury bills
___________________
etc.) as well as agricultural commodities and precious metals,
___________________
expectation of future price changes influences the market
demand. ___________________
___________________
Other or specific factors like credit facilities, seasonal changes
and changes in macroeconomic policies also have a significant
effect on the demand of a product. In case of durable goods,
factors like availability of credit facilities, after sales service,
brand loyalty and product features play a crucial role in
determining demand.
Check Your Progress

Fill in the blanks:
1. The demand function is ....................
2. The segment of population which consumes a particular
good or service is called ....................
Summary
Demand shows what customers are willing and able to purchase at
each and every price, not only what they want to buy. A movement
along a demand curve occurs when there is a change in the price,
all other things being unchanged. A shift in the demand curve
occurs when more or less is demanded at each and every price. A
demand curve is usually downward-sloping, but in some cases
(such as a Veblen or Giffen good), it can be upward-sloping. The
marginal utility shows the extra utility from consuming a unit; the
total utility shows the total satisfaction that a consumer has from
consuming a product. The marginal utility from consuming a
product declines when additional units are consumed.
38
Lesson End Activity
Notes
A demand curve can be derived using indifference curve analysis.
___________________
This analyses the impact of a change in price and income in terms
___________________ of consumers’ utility. To find out more about indifference curve
___________________ analysis and how a consumer maximizes utility, visit the Online
___________________
Resource Centre.
___________________ Visit the Online Resource Centre at

http://www.oxfordtextbooks.co.uk/orc/gillespie_econ2e/
___________________
___________________
Keywords
___________________
Complementary goods: These are goods that are often consumed
___________________
simultaneously.
___________________
Demand: Demand is the desire for the product backed by
willingness and ability to pay for it.
Demand Function: A demand function is a comprehensive
formulation in an equation form, which specifies the major factors
that influence the demand for a product.
Socio-cultural factors: These are factors like customs and
religious practices determine the preferences and tastes of the
consumer.
Substitutes goods: These are goods which can replace the
demand for each other.

1. Define demand.
2. Explain the concept of Demand Function.
3. Does the quantity demanded always fall if the price increases?
4. To what extent do you think a business can control the

demand for its products?
Further Readings
Books
Managerial Economics by Christopher R Thomas, S Charles
Maurice – Special Indian, 8th Ed, McGraw Hill Education.
39
Managerial Economics by Atmanand, 2nd Edition, Excel Books
Notes
Publication
Managerial Economics by Karampal and Surender Kumar, 1st ___________________
Edition. Excel Books Publication. ___________________
___________________
Web Readings
___________________
www.adb.org/documents/handbooks/water_supply.../Chap3-r6.PDF
___________________
nptel.iitm.ac.in/courses/Webcoursecontents/IIT...e/.../2slide.html
___________________
www.nvc.vt.edu/abon/micro_analysis.ppt
___________________
___________________
___________________
___________________
40
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 6: Law of Demand
Unit 5
47
Notes
Law of Demand
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Concept of law of demand ___________________

\ Exceptions to the law of demand ___________________
\ Movement and Shifts in Demand
___________________
___________________
Introduction
___________________
It has been observed that the so-called 'customer power' has
increased considerably with economic liberalization (1980s and
1990s) and customer protection laws. For this reason, the focus of
the companies nowadays seems to be on building 'customer share
rather than market share'. In this context, analysis of consumer
demand commands greater relevance. Such knowledge also helps
in making pricing decisions, forecast sales and formulate
marketing strategies.
The degree of change in demand cannot be assessed by demand
curves and demand schedules. Therefore, in this unit we will
introduce the concept of elasticity that studies the magnitude of
change in demand. Another important topic covered in this unit is
demand forecasting. Predicting future events can solve real world
problems of risk and uncertainty. Different forecasting techniques
can be applied for short-term and long-term predictions.
Concept of Law of Demand

The law of demand states that, other factors held constant, as price
of a good or service increases, its quantity demanded by consumer's
decreases. The law shows that there is an inverse relation between
price and quantity demanded. Managers should be aware that the
law indicates that a price change will have an impact on a firms'
sales volume and total volume and thus, its profitability. It should
be noted that the law is applicable when other factors influencing
demand are taken as constant and only price is changed. The law
48
can be depicted in the form of a demand schedule and demand
Notes
Activity curve.
State the law of demand.
___________________
The demand schedule for a good is a table that shows the total
___________________ quantity of a good that will be purchased at various prices.
___________________ Suppose there are two buyers for computers in the market, namely
___________________
buyer X and buyer Y.
Table 6.1: Demand Schedule for PC's
___________________
Price (` ‘ooo) Buyer X Buyer Y Market Demand
___________________
50 100 80 180
___________________
40 150 120 270
___________________ 30 200 170 370
___________________ 20 350 250 600

10 600 350 950
___________________
The demand by buyer X and buyer Y are individual demands.
Total demand by the two is market demand. Thus, the total
market demand can be derived by adding the quantity of a good
demanded by all buyers, at various price. Table 6.1 shows that the
market demand for computers is 950 per year at ` 10,000 and 600
computers will be demanded at ` 20,000, and so on.
A demand curve is a graphical depiction of price-quantity

relationships. In Figure 6.1, Dx and Dy are individual demand
curves and Dm is the market demand curve which is derived by
horizontal summation of individual demand curves. Each point on
the demand curve shows a unique combination of price and
quantity. It can be observed from Figure 6.1 that the demand curve
slopes downwards to the right. Now the question that arises is:
z Why does the demand curve slope downwards to the right? Or
z Why does the law of demand operate?
Figure 6.1: Demand Curve for PC's

The law can be explained in terms of substitution and income
49
effect. When the price of a good falls (prices of related goods
Notes
remaining constant), it becomes relatively cheaper than other Activity
goods. For instance, the quantity purchase of relatively more List___________________
the cases where the
exceptions to law of demand
oranges, when the price of apples increases is due to apply.
___________________
substitution effect. Therefore, substitution effect is due to
___________________
consumers' inherent tendency to substitute cheaper goods for
the relatively expensive ones. Income effect arises with an ___________________
increase in the purchasing power of the consumer due to a
___________________
decrease in the price of the good. That is, at lower prices the
individual can buy same bundle of goods with lesser money or ___________________
he can buy more of the same good with the same money. The ___________________
change in the purchasing power of the consumer due to a
___________________
price change is called income effect.
___________________
Check Your Progress
___________________
Fill in the blanks:
1. The ................... states that, other factors held constant,
as price of a good or service increases, its quantity
demanded by consumer's decreases.
2. The ................... for a good is a table that shows the
total quantity of a good that will be purchased at
various price.
Exceptions to the Law of Demand

The law of demand is not applicable in certain cases:
(a) The law of demand is violated in case of Veblen or conspicuous

goods. Some goods are purchased for snob appeal, ostentation
and prestige value. As a result higher their price, the greater
is their demand. Diamonds, antique pieces and rare paintings
are purchased more at a high price due to an increase in the
prestige value attached to them.
(b) Giffen goods or inferior goods are another category of goods

that depict direct price - demand relationship. A Giffen good is
an inferior commodity, much cheaper than its superior
substitutes, consumed by poor households as an essential
commodity. An increase in the price of such good increases its
demand. Inferior quality rice, bajra and potatoes fall in this
category.
(c) The law of demand does not apply in case of speculation.

Consumers tend to purchase more at a high price expecting
50
the prices to rise in future. This is usually due to sudden
Notes
Activity scarcity of goods especially in case of necessities and shares in
Define the movement along
___________________ stock market.
the demand curve.
___________________
1. ................... are purchased for snob appeal, ostentation
___________________ and prestige value.
___________________ 2. ................... is an inferior commodity, much cheaper
___________________ than its superior substitutes, consumed by poor
households as an essential commodity.
___________________
___________________ Movements and Shifts in Demand

___________________
Change in quantity demanded due to a change in price is called as
a movement along a demand curve. It measures the effect of a
change in price while other factors influencing demand are taken
as constant. In Figure 6.2(a) a decrease in price from P to P2 leads
to an expansion of quantity demanded from Q to Q2 and an
increase in price to P1 results in contraction of demand to Q1.
Price Price
(a) (b)
E1
P1
P
E2 P D1
P2 D
D
O O D2
Q1 Q Q2 Quantity Q2 Q Q1 Quantity
Figure 6.2: Movements and Shifts in Demand
Changes in non-price determinants (price remaining constant)

result in changes in demand, that is, shift in the demand. In the
Figure 6.2 (b) the demand curve shifts to the right from D to D1
with an increase in demand. An increase in income, rise in price of
substitutes, increase in population, decrease in price of
complements, change in tastes in favour of a good, and advertising,
increase the demand of a good. Leftward shift in the demand curve
from D to D2 indicates a decrease in demand. This is due to a
decrease in income, a fall in price of substitutes, decrease in prime
population, a rise in price of complements and change in tastes
against the good.
A comparison between the two concepts is done in Figure 6.3. The 51
increase in quantity demanded from OQ to OQ1 can be Notes
attributed to (a) a decrease in price from P to P1 along the
___________________
demand curve D1 and (b) an increase in demand due to a shift in
demand from D1 to D2. In the second case, the price is constant at ___________________
P while other factors ___________________
like increase in income, increase in prime population etc., lead to
___________________
an upward shift in demand curve.
___________________
Price
___________________
___________________
L
___________________
P N
D3 ___________________
P1 M
D2 ___________________
O D1
Q Q1
Quantity
Figure 6.3: Comparison between Movement and

Shift in Demand
In the former case, demand expands by partly foregoing some

amount of revenue (since TR = P × Q). On the other hand, shift in
demand leads only to an increase in revenue. But it should be
noted that, increase in demand due to advertising and sales
promotion techniques is possible only with additional cost.
Managers should try to increase demand with the latter method by
taking additional cost into account.
Check Your Progress

Fill in the blanks:
1. Change in quantity demanded due to a change in price
is called as a ....................
2. Changes in non-price determinants (price remaining
constant) result in changes in demand, that is,
....................
Summary
A desire for goods or services become effective demand when there
is a desire to buy, ability to pay and willingness to pay. There are
various factors influencing the demand for the product for example
52 price of the product, income of the consumer, preference and tastes

Notes of consumers, price of related goods etc. The Law of Demand states
___________________ keeping other factors constant, the quantity demanded for a
product increases with decrease in the price and vice versa.
___________________
___________________
Keywords
___________________
___________________ Advertisement: Advertisement or promotional elasticity of

demand is the ratio of percentage change in quantity demanded to
___________________
a percentage change in advertisement outlay.
___________________
Autonomous Demand: It is not linked to demand of any other
___________________
product. It is independent of demand of any other good.
___________________
Demand curve: It is a graphical depiction of price-quantity
___________________ relationships.
Giffen goods or inferior goods: These are an inferior commodity,

much cheaper than its superior substitutes, consumed by poor
households as an essential commodity.
Movement along a demand curve: It is the change in quantity

demanded due to a change in price.
Shift in the demand: It is the changes in non-price determinants
(price remaining constant) result in changes in demand.
Veblen or conspicuous goods: These goods are purchased for

snob appeal, ostentation and prestige value.
1. State and illustrate the law of demand with examples.
2. What are the exceptional points in case of Law of Demand?
3. Does a demand curve show what a consumer would like to buy

at each and every price?
4. What is the difference between a movement along, and a shift

in, a demand curve?
5. Does an increase in income always shift the demand curve to

the right? Explain your answer.
Further Readings 53
Notes
Books
___________________
Managerial Economics by Christopher R Thomas, S Charles ___________________
Maurice – Special Indian, 8th Ed, McGraw Hill Education.
___________________
___________________
Publication
___________________
Managerial Economics by Karampal and Surender Kumar, 1st
Edition. Excel Books Publication. ___________________
___________________
Web Readings
___________________
___________________
nptel.iitm.ac.in/courses/Webcoursecontents/IIT...e/.../2slide.html ___________________
www.nvc.vt.edu/abon/micro_analysis.ppt
54
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 7: Elasticity of Demand
Unit 6
55
Notes
Elasticity of Demand
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Concept of elasticity of demand ___________________

\ Price elasticity of demand ___________________
\ Income elasticity of demand
___________________
\ Cross-elasticity of demand
___________________
___________________
Introduction
Elasticity of demand is the responsiveness of the quantity
demanded of a good or service to a change in any one variable
influencing demand. As such there is a specific type of elasticity for
a single determinant of demand. We will discuss about price,
income, cross, and promotional elasticities of demand. Various
pricing decisions and policy decisions are dependent on these
demand elasticities.
Determinants of Price Elasticity

Let us look into the reasons for the demand for some goods being
elastic and others inelastic. The main factors governing the
magnitude of price elasticity are discussed here.
1. Closeness of Substitutes: The price elasticity for a product is

high if it has numerous close substitutes. Increase in the price
of the product results in consumers buying close substitutes.
Hence the price elasticity of demand for a particular brand of
product is higher than the product as a whole. It is for this
reason that the demand curve faced by a firm is more elastic
than the one faced by the corresponding industry. For
instance, the demand for cold drinks is inelastic but the
demand for Coke is elastic.
2. Nature of the Good: In general, luxury goods are price

elastic and necessities are price inelastic. Demand for PCs is
more responsive to change in price while demand for wheat
56
has low elasticity, since it is an essential commodity. But the
Notes
Activity luxury/necessity dichotomy is ambiguous. This is so because
List___________________
the determinants of price one person's luxury is another person's necessity. For
elasticity.
example, demand for premium end automobiles may be
___________________
elastic, but a high price of Mercedes may not affect demand
___________________ for consumers who regard it as a necessity.
___________________
3. Proportion of Income Spent: The greater the income spent
___________________ on a good the greater the elasticity of demand, and vice versa.
___________________
Demand for common salt, matches, and buttons may be highly
inelastic because a typical consumer spends a very small
___________________
fraction of his income on such goods. In contrast, demand for
___________________ goods like TV and clothing tends to be elastic, as they
constitute a major proportion of consumers' budget.
___________________

Fill in the blanks:
1. ................... in the price of the product results in
consumers buying close substitutes.
2. In general, luxury goods are price elastic and
necessities are price ....................
Price Elasticity of Demand (Ep)

The price elasticity of demand is the ratio of a percentage change
in quantity demanded and the percentage in price, other factors
remaining constant. It measures the responsiveness of sales of a
good to changes in its price. It can be written as:
Percentage change in quantity demanded
Ep =
Percentage change in price
Δ/Q
=
P/P
ΔQ P
= ⋅
ΔP Q
Where ΔQ and ΔP refer respectively to incremental change in

quantity and change in price. ΔQ and ΔP depict original quantity
and price. It should be noted that Δ refers to absolute change while
ΔQ/Q is a percentage change.
Suppose a 1% reduction in price is followed by a 1.3% increase in

quantity demanded then the price elasticity is 1.3. An elasticity of
–2 is greater than an elasticity of -1 even though algebraically, the
opposite may be true. The elasticity is given a positive sign 57
despite inverse relation between price and quantity demanded Notes
Activity
to make analysis simple. Give the formula for income
___________________
elasticity of demand.
Check Your Progress ___________________
Fill in the blanks: ___________________
1. ................... measures the responsiveness of sales of a ___________________

good to changes in its price. ___________________
2. The elasticity is given a ................... sign despite ___________________

inverse relation between price and quantity demanded ___________________
to make analysis simple.
___________________
Income Elasticity of Demand (Ei) ___________________
___________________
Income elasticity is the ratio of a percentage change in the
quantity demanded to a percentage in income, other factors
remaining constant. The point income elasticity of demand is
Δ Q / Q ΔQ I
Ei = = ⋅
ΔI/ I ΔI Q
Where ΔQ and ΔI refer to change in quantity and change in income

respectively. Note that Ei measures the shift in the demand curve
at each price level.
To determine the arc income elasticity of demand we use the

average of the original and new incomes and quantities.
Ei =
ΔQ
⋅
b g
I2 + I 1 / 2 Q − Q1 I 2 + I1
= 2 ⋅
b
ΔI Q 2 + Q 1 / 2 g I 2 − I1 Q 2 + Q 1
Where, the subscripts 1 and 2 refer to the original and the new
levels of income and quantity respectively, or vice versa.
Income Elasticity can be Positive or Negative

It is positive (Ei > 0) for normal or superior goods. An increase in
income leads to an increase in consumption. Inferior goods have
negative (Ei < 0) income elasticity. Different types of goods have
varying positive income elasticities.
1. Necessities have low income elasticity (Ei < 1). A change in

sales of goods, like wheat and sugar, is likely to be less, to a
proportionate change in income.
58
2. Luxuries have more than proportionate change in sales with a
Notes
Activity
change in income (Ei >1). Demand for cars and TV increases
Give___________________
the formula for the cross
elasticity of demand. more than proportionately with an increase in income. It
___________________ means that their demand is highly cyclical or sensitive to
___________________ income.
___________________ Uses of Income Elasticity

___________________
(i) Income elasticity for a firm is useful in estimation and
___________________ prediction of demand in the long run. Firms making products
___________________ with high income elasticities are likely to grow rapidly as
incomes rise in an expanding economy and products with low
___________________
income elasticities are likely to experience modest expansion.
___________________ Suppose the elasticity for automobiles is 3, it means that a 1%
___________________ increase in disposable income will lead to a 3% increase in
quantity demanded.
(ii) Income elasticity is also useful in identifying the market for
the product on the basis of the type of product the consumers
are likely to purchase more with an increase in income.
(iii) Income elasticity is helpful in forecasting change in demand
for the good a firm sells in different economic conditions. The
demand for a good with low income elasticity will not fluctuate
much with a recession or boom. But the demand for luxuries
will rise with boom and fall sharply during recession.
Check Your Progress

Fill in the blanks:
1. ................... for a firm is useful in estimation and
prediction of demand in the long run.
2. The demand for a good with ................... income
elasticity will not fluctuate much with a recession or
boom.
Cross Elasticity of Demand (Exy)

The cross elasticity of demand measures the responsiveness of
demand for good X to a change in price of good Y. It is the ratio of a
percentage change in the demand for good X to a percentage
change in price of good Y, other factors remaining constant. Point
cross elasticity is given by
59
ΔQx / Qx ΔQx Py
Exy = = ⋅ Notes
ΔPy / Py ΔPy Qx
___________________
Where ΔQx and ΔPy refer respectively to the change in quantity
___________________
demanded of good X to a change in the price of good Y.
___________________
Arc cross price elasticity of demand is measured with the following
formula: ___________________
Exy = ⋅
b
ΔQx Py 2 + Py 1 g
=
Qx 2 − Qx 1 Py 2 + Py 1
⋅
___________________
b
ΔPy Qx 2 + Qx 1 g Py 2 − Py 1 Qx 2 + Qx 1 ___________________
___________________
Where subscripts 1 and 2 refer to the original and to the new levels
of income and quantity, respectively, or vice versa. ___________________
The elasticity coefficients give significant results about the type of ___________________
goods. ___________________
(a) If value of Exy is positive the two goods are substitutes (like
Coca cola and Pepsi), because an increase in price of Y (Py)
leads to an increase in quantity of X (Qx) as X is substituted
for Y in consumption.
(b) If Exy is negative, goods X and Y are complementary (like
petrol and cars), because an increase in Py leads to a
reduction in Qx and Qy.
(c) If Exy is zero or close to zero then the two goods are totally
unrelated or independent goods (like books and beer).
The concept is used to anticipate the effect on the sales of a firm to

a change in price of their rivals. For example, the MUL can
measure the effect of a change in the prices of Santro or Matiz on
the demand for Zen.
Uses of Elasticity of Demand for Managerial Decision Making
The analysis of variables that affects demand and numerical

estimates of these variables are essential for the firm to make the
best operating decision and to make plan for its growth. The firm
needs these elasticity estimates in order to determine the
operational policies and the most effective way to respond to the
policies of competing firms. For taking decisions on a pricing
policy, the businessman has to know the likely effects of price
changes on the demand for his product in the market. It is also
important to know the extent to which a change in the unit price
will affect the demand for the product. He can calculate the
60
increase in the demand for the product and to what extent, if the
Notes
prices are lowered and whether it will result in substantial
___________________ increase in the revenue and profit. In the case of elastic demand,
___________________
the total revenue will decrease with the rise in the price, whereas,
in the case of inelastic demand the total revenue will increase with
___________________
the rise the price. If the firm estimated that cross elasticity of
___________________ demand for its product with respect to the price of competitor's
___________________
product is very high. It will respond very quickly to the competitor
price reduction, otherwise, the firm would lose a great deal of its
___________________
sale. However the firm would think twice before lowering its price
___________________ for fear of starting a price war. It is important for managers to
___________________
understand the price elasticity of their products and services in
order to set prices appropriately to maximize firm profits and
___________________
revenues.
___________________
Measurement of Elasticity of Demand
There are two approaches of computing elasticity. The choice

between the two depends on the available data and intended use.
(a) Arc elasticity: Arc elasticities are appropriate for analyzing

the effect of discrete, i.e. measurable, changes on price. For
example, a price increases from ` 2 to ` 4 could be evaluated
by computing the arc elasticity. In actual practice, most
elasticity computations involve the arc method. Arc elasticity
measures the incremental changes between two points on a
demand curve. To avoid ambiguity in elasticity coefficients,
arising due to choice of price and quantity, averages of the
original and new quantity and price are used.
Ep =
ΔQ
. 2
b g
P + P1 / 2
b g
ΔP Q 2 + Q 1 / 2
Q − Q 1 P2 + P1
= 2 .
P2 − P1 Q 2 + Q 1
were subscripts 1 and 2 refer to the original and to the new

values respectively.
(b) Point elasticity: It refers to measurement of elasticity on a

point on a demand curve. Point elasticity helps in measuring
elasticity where change in price and quantity is
infinitesimally small. As marginal analysis works by
evaluating small changes taken with respect to an initial
decision, it is often useful to measure elasticity w.r.t.
infinitesimally small changes in price. In this case we write 61
elasticity as Notes
dQ/Q ___________________
Ep =
dP/P
dQ P ___________________
= .
dP Q ___________________
Where dQ/dP is the derivative of quantity w.r.t. price at a ___________________

point on a demand curve and P and Q are the price and ___________________
quantity at that point.
___________________
To measure the point elasticity on a non-linear demand curve, we ___________________
first draw a tangent through the point. For example, to measure
___________________
point elasticity at point R on demand curve Dx, tangent AB is
drawn through the point. The slope of the demand curve and of the ___________________
line is same at that point so that the elasticity of the demand curve ___________________
at point R will be equal to that of the line at this point. The
elasticity of the line at point R can be measured as follows
dQ P
Ep = .
dP Q
The reciprocal of the slope of the straight line AB at point R is NB /

RN. Therefore
dQ NB
=
dP RN
At point R price P = RN and quantity Q = ON. By substituting

these values in the elasticity equation, we get
NB RN NB
Ep = . =
RN ON ON
Geometrically,
NB RB
=
ON RA
Price
(Ep = ∞)
A
Ep > 1
Ep = 1
M
R Ep < 1
Dx
(Ep = 0)
O
N B
Quantity
Figure 7.1: Point Elasticities of Demand

62
Therefore, it can be said that price elasticity of demand at any
Notes point on a linear demand curve is equal to the ratio of lower
___________________ segment to the upper segment of the line. That is
___________________ Lower segment
Ep =
Upper segment
___________________
___________________ If we consider similar triangles AMR and RNB then RA/RM =

___________________ RB/NB (from properties of similar triangles) or NB/RM = RB/RA.
___________________
Hence, elasticity = NB/ON can be written as equal to RB/RA. That
is elasticity at point R is the ratio of lower segment of the demand
___________________
curve to the upper segment. If the demand curve were linear, this
___________________
method would be simplified as the tangent to the curve at a point
___________________ would coincide with the curve itself.
___________________
It can be seen from Figure 7.1 that the ratio of RB/RA falls as we
move down the demand curve, since the length of RB decreases
and of RA increases. Due to this reason at mid-point of a linear
demand curve, Ep = 1, as shown at point R. At point A, RA is zero,
therefore, the elasticity is infinite (Ep = infinity). At point B,
elasticity is zero (Ep = 0) since RB is zero. Hence elasticity falls
from infinity to zero as one moves down the linear demand curve.
It follows that at any point to the left of point R, demand is elastic
(Ep > 1), and at any point to the right of point R, demand is
inelastic (Ep< 1).
Price Elasticity and Prediction
Knowledge of price elasticity is important for two reasons:
(i) It helps firms to predict the impact of price change on unit

sales, and
(ii) Guides the firms’ profit maximization pricing decision.
Managers are concerned with whether a change in price in either

direction will increase or decrease revenue. We know that
elasticity is percentage change in quantity demanded divided by
percentage change in price. Therefore, if the former is larger, then
the quantity effect is stronger and will more than offset the
opposite price effect. Thus, it can be said that the elasticity
coefficient influences the revenue of the firm. Now what does this
coefficient entail for revenue?
Table 7.1: Price Elasticity and Total Revenue 63
Notes
Price elasticity Interpretation Total Revenue (TR)
coefficient ___________________
Price increase Price ___________________
decrease
___________________
Perfectly elastic Only one possible TR falls to zero Infinite, Size of
demand E price. Unlimited market ___________________
=infinity quantity sold at that determines TR
price. ___________________
(Figure 7.2 a)
___________________
Elastic demand E Percentage ∆Q is TR decreases TR increases
> 1 (Figure 7.2c) greater than the ___________________
percentage ∆P
___________________
Unitary elastic Percentage ∆Q is TR is unaffected TR unaffected
demand E = 1 equal to percentage by price changes by price change ___________________
∆P
(Figure 7.2d) ___________________
Inelastic demand Percentage ∆Q is less TR increases TR decreases
E<1 than percentage ∆P
Perfectly inelastic Percentage ∆Q TR increases TR decreases

demand E = 0 remains same to ∆P
If price decreases and, in percentage terms, quantity rises more

than the decrease in price, then total revenue will increase and
vice versa. Economists have classified elasticity coefficients in five
categories. The relationship between various types of elasticity and
total revenue has been summarized in Table 7.1 where ΔQ and ΔP
refer to change in quantity demanded and change in price
respectively.
The five types of price elasticities presented in Table 7.1 are shown
graphically in Figure 7.2. Perfectly elastic and perfectly inelastic
price elasticity of demand is the two extremes on the elasticity
scale. Most of the goods and services fall under the category of
elastic and inelastic demand. Figure 7.2 (c) depicts that when
demand is more elastic (E > 1) a decrease in price results in a
proportionately greater change in demand (QQ2 > PP1). When
demand is less elastic (E < 1), a smaller change in demand takes
place with a change in price (QQ4 < PP1) as shown in Figure 7.2 (e).
A proportionate change in demand takes place with a change in
price (QQ3 = PP1) when elasticity is unity (E = 1).
64
Notes
Activity
Define the advertisement
___________________ Price (a) P (b)
elasticity of demand.
___________________ E = Infinity E=0
___________________
P P
___________________ D1 P1
___________________
O O Q
___________________ Quantity Q
___________________ Price (c) (d) (e)

E>1 E=1 E<1
___________________
___________________ P
P1
___________________
D2 D3 D4
O O O
Q Q2 Q Q3 Q Q4
Quantity
Figure 7.2: Types of Price Elasticities of Demand
Check Your Progress

Fill in the blanks:
1. ................... is the ratio of a percentage change in the
demand for good X to a percentage change in price of
good Y, other factors remaining constant.
2. ................... elasticities are appropriate for analyzing
the effect of discrete, i.e. measurable, changes on price.
3. If price decreases and, in percentage terms, quantity
rises more than the decrease in price, then total
revenue will ................... and vice versa.
Advertisement Elasticity of Demand (EA)

Advertisement or promotional elasticity of demand (EA) is the ratio
of percentage change in quantity demanded (Q) to a percentage
change in advertisement outlay (A).
ΔQ A
EA = ⋅
ΔA Q
The greater the promotional elasticity, the more will be the 65
incentive to go in for advertising. The advertisement elasticity of Notes
sales varies between zeros to infinity.
___________________
1. If EA = 0, then sales do not respond to the advertisement ___________________
expenditure.
___________________
2. When EA < 1 is positive, then sales increase in proportionately
___________________
lesser degree than the increase in advertisement outlay.
___________________
3. Sales increase in equal proportion to advertisement outlay if
___________________
EA = 1.
___________________
4. When EA > 1 then sales increase more than proportionately to
___________________
the increase in advertisement budget.
___________________
Check Your Progress
___________________
Fill in the blanks:
1. ................... is the ratio of percentage change in
quantity demanded (Q) to a percentage change in
advertisement outlay (A).
2. The greater the promotional elasticity, the ...................
will be the incentive to go in for advertising.
Summary
There are various factors influencing the demand for the product
for example price of the product, income of the consumer,
preference and tastes of consumers, price of related goods etc. The
Law of Demand states keeping other factors constant, the quantity
demanded for a product increases with decrease in the price and
vice versa. Veblen effects, Giffen goods, speculative motive etc., are
some exceptions to the Law of demand. The responsiveness of the
quantity demanded to a change in any of the variables of demand
is known as elasticity of demand.
Lesson End Activity

Take any product of your choice and evaluate its cross elasticty
and price elasticity of the demand.
Keywords
Cross Elasticity of Demand: Measures the responsiveness of
demand for good X to a change in price of good Y.
66
Demand: It is the desire for the product backed by willingness and
Notes ability to pay for it.
___________________
Elasticity of Demand: It is the responsiveness of the quantity
___________________ demanded of a good or service to a change in any one variable
influencing demand.
___________________
___________________ Income Elasticity: It is the ratio of a percentage change in the

quantity demanded to a percentage in income, other factors
___________________
remaining constant.
___________________
Price Elasticity of Demand: It is the ratio of a percentage
___________________
change in quantity demanded and the percentage in price, other
___________________ factors remaining constant.
___________________
___________________
1. What do you understand by price elasticity of demand? What
are the various ways to measure it?
2. Given is the list of goods. Will their demand be less elastic,
moderate elastic, highly elastic or completely inelastic? Give
reasons to support your answer.
(i) Petrol
(ii) Milk
(iii) Cars
(iv) Salts
(v) Bajra
(vi) Cellular services
(vii) Seasonal vegetables
Further Readings
Maurice- Special Indian, 8th Ed, McGraw Hill Education.
Publication
Web Readings
en.wikipedia.org/wiki/Price_elasticity_of_demand
en.wikipedia.org/wiki/Elasticity_(economics)
www.mgmtmaterial.com/elasticity_of_demand.html
UNIT 8: Demand Forecasting – Concept and Survey Methods
Unit 7
67
Notes
Demand Forecasting – Concept

___________________
___________________
and Survey Methods ___________________
___________________
Objectives ___________________
___________________
topics:
___________________
\ Significance of demand forecasting
\ Demand forecasting methods ___________________
\ Survey methods of demand forecasting ___________________
___________________
Introduction
Forecasting is the prediction of demand for a good or service, for

the forecast period, on the basis of present and past behaviour
patterns of some related events. It is often used to predict the
growth in demand or sales growth, assess the possible market
share and to gather information on proper product–mix. These
forecasts help companies to reduce risk and uncertainty associated
with such short run operational decision making. Overproduction
and underproduction can be avoided in the near future by these
measures. Long run production decisions like purchase of plants,
advertising of product, and major capital investments can be made
with the help of forecasts.
A good forecast should be accurate, simple, economical, consistent
and timely. A sound estimate of future demand should be based on
adequate knowledge of relevant past. The forecast should be
simple to understand, made within the allocated budget, and
consistent with the objectives of the firm. It should be made within
the time limit.
Significance of Demand Forecasting

1. Production planning: Demand forecasting is the
prerequisite for production planning. Expansion of output is
based on the estimates of likely demand for the product. If
produced more than the estimated quantity demanded, it will
result in piling up of stock (inventory), thereby increasing
unnecessary cost of storage and maintenance.
68
2. Sales forecasting: Sales forecasting is based on demand
Notes
Activity forecasting. Accordingly advertisement and other sales
State any two points depicting
___________________ promotional activity can be planned out.
the importance of demand
forecasting.
___________________ 3. Control of business: All the activities of the business depend
on demand forecasting. Preparing of budgets, allocating costs,
___________________
estimating profits etc., depends on demand and sales forecast
___________________ and price of the product.
___________________
4. Inventory Control: Requirement of inventories, raw
___________________ material, semi materials, spare parts, etc., depends on the
future requirement which can be traced from the estimated
___________________
demand for the product.
___________________
5. Growth and long term investment programmes
___________________
6. Stability
___________________
7. Economic planning and policy making
Check Your Progress

Fill in the blanks:
1. ................... is the prediction of demand for a good or
service, for the forecast period, on the basis of present
and past behaviour patterns of some related events.
2. .................. is based on the estimates of likely demand
for the product.
Methods of Demand Forecasting

Survey Methods of Demand Forecasting
Survey Methods
Opinion Poll Consumer Survey

Methods Methods
Expert Delphi Complete Sample Survey

Opinion Method Method Enumeration Method Method
Figure 8.1: Types of Demand Forecasting by Survey Methods

The survey methods can be divided into two broad categories.
69
Opinion Poll Method Notes
Activity
List the various methods of
The opinion poll methods aim at collecting opinions of those ___________________
demand forecasting.
who are supposed to possess knowledge of the market, such as ___________________
sales representatives, sales executives, professional marketing
___________________
experts and consultants. In these methods the expert opinion is
surveyed. The forecaster identifies the experts on the ___________________
commodity to be surveyed and takes their opinion on the; ___________________

likely demand for the commodity. E.g. the future demand of
___________________
car can be forecasted by taking opinions of experts of
automobile industry, research organizations where such ___________________
researches are carried, owners of various car companies. The ___________________
opinion poll methods will be discussed in detail in the following
___________________
sections.
___________________
1. Expert-opinion method,
2. Delphi method.
1. Expert-opinion Method: Firms having a good network of

sales representatives can put them to the work of assessing
the demand for the product in the areas, regions or cities that
they represent. Sales representatives, being in close touch
with the consumers or users of goods, are supposed to know
the future purchase plans of their customers, their reaction to
the market changes, their response to the introduction of a
new product and the demand for competing products. The
estimates of demand thus obtained from different regions are
added up to get the overall probable demand for a product.
2. Delphi Method: This method is used to consolidate the

divergent expert opinions and to arrive at a compromise
estimate of future demand. The process is simple.
Under the Delphi method, the experts are provided

information on estimates of forecasts of other experts along
with the underlying assumptions. The experts may revise
their own estimates in the light of forecasts made by other
experts. The consensus of experts about the forecasts
constitutes the final forecast.
Consumer Survey Method
Demand forecasting by consumer survey methods is done by taking

the view of the consumers directly about their future plans about a
product. Various methods are adopted for surveying the consumer.
70
Forecasting of demand is done by consumer survey methods by
Notes
surveying and asking them about the future consumption plan of a
___________________ product. These methods will also be discussed in the following
___________________ sections.
___________________ 1. Complete Enumeration Method: The forecaster undertakes

___________________
a complete survey of all consumers whose demand intends to
forecast. In the complete enumeration method, almost all
___________________
potential users of the product are asked about their future
___________________ plan of purchasing the product. The quantities given by the
___________________ consumers about the purchase plan of the product are added
together to obtain the probable future demand of the product.
___________________
The total probable demand can be indicated by the equation.
___________________
D = d1 + d2+ d3+………..+dn
___________________
= Σdi
Where di, d2, d3………..dn shows demand of individual
consumers 1, 2, 3…..n, and D is the probable D.
2. Sample Survey Method: In this method, a sample is selected

to represent the entire population of consumers. The probable
demand of a product expressed by each unit of the sample is
added to get the total demand of the product. The total
demand of the product is estimated by the formula
Df = Cd/Cs(Ct*Qt/Cs)
Where Df = probable forecast, Ct = total number of consumers in

the market, Cs = number of consumers surveyed or sample
consumers, CD = number of consumers reporting future
consumption of the product and Qt = total quantity of the product
to be consumed by the sample.
Check Your Progress

Fill in the blanks:
1. The ................... methods aim at collecting opinions of
those who are supposed to possess knowledge of the
market, such as sales representatives, sales executives,
professional marketing experts and consultants.
2. Under the ................... method, the experts are provided
information on estimates of forecasts of other experts
along with the underlying assumptions.
Summary 71
Notes
The main objective of the demand forecasting is to minimize the
risk that the firm faces in its decision making process. Data forms ___________________
the basis for business forecasting. These can be obtained ___________________

from expert opinion, surveys and market experiments for ___________________
use in forecasting. By considering the advantages and
___________________
limitation of different forecasting techniques, business
managers can choose methods or their combinations that ___________________
most suitable to the firm. Forecasting methods range from ___________________

naive and inexpensive to be sophisticated and costly.
___________________
___________________
Lesson End Activity
___________________
Give an example where the survey for the demand of any product
___________________
has been forecasted with the help of opinion poll methods.
Keywords
Demand: Demand is the desire for the product backed by

willingness and ability to pay for it.
Delphi Technique: Way of getting repeated opinion of experts
without their face to face interaction.
Forecasting: Forecasting is the prediction of demand for a good or

service, for the forecast period, on the basis of present and past
behavior patterns of some related events.
Group Discussion: Decisions may be taken with the help

of brainstorming sessions or by structured discussions.
1. Why is demand forecasting so significant for the firm?

2. What are different types of forecasting methods? How can the
firm determine the most suitable forecasting method to use?
3. Explain the survey methods of forecasting.
4. What do you understand by the delphi method of demand
forecasting?
72
Further Readings
Notes
___________________ Books
___________________ Managerial Economics by Christopher R Thomas, S Charles
___________________ Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
___________________ Miller. R.E., and P.D. Blair: Input and Output Analysis;
___________________ Foundations and extensions (Englewood Cliffs., N.J.: Prentice Hall,
1985).
___________________
Granger, C.W.: Forecasting in Economics and Business (New York:
___________________
Academic Press, 1989).
___________________
Himilton, J.D.: Time Series Analysis (Princeton, N.J. Princeton
___________________
University Press, 1994).
___________________
Salvatore, Dominick: Microeconomic Theory and Applications, 3rd
Ed (Reading, Mass, Addison Wesley, 1997).

Publication.
Web Readings
en.wikipedia.org/wiki/Demand_forecasting
UNIT 9: Statistical Methods of Demand Forecasting
Unit 8
73
Notes
Statistical Methods of Demand

___________________
___________________
Forecasting ___________________
___________________
Objectives ___________________
___________________
topics:
___________________
\ Statistical methods of forecasting
\ Trend projection methods ___________________
\ Barometric Methods ___________________

\ Econometric methods ___________________
Introduction
In this unit, we provide brief descriptions of forecasting methods
and their application.
Forecasting methods and the relationships between them are
shown in the next section, starting with the primary distinction
between methods that rely on survey and those that require
quantitative data.
Sometimes it is appropriate to forecast demand directly. For
example, a baker might extrapolate historical data on bread sales
to predict demand in the week ahead. When direct prediction is not
feasible, or where uncertainty and changes are expected to be
substantial, marketing managers may need to forecast the size of a
market or product category. Also, they would need to forecast the
actions and reactions of key decision makers such as competitors,
suppliers, distributors, collaborators, governments, and themselves
– especially when strategic issues are involved. These actions can
help to forecast market share.
Statistical Methods of Demand Forecasting

Demand forecasting by statistical methods are more complex than
survey methods. Survey methods are based on opinion of
consumers or experts. Statistical methods are based on data for
74
estimating future demand. The different methods of demand
Notes
Activity forecasting by using statistics are given in the chart below.
Identify the various statistical
___________________
methods available for demand
Statistical Methods
forecasting.
___________________
___________________
Trend Projection Barometric Econometric
___________________ Methods Methods Methods
___________________
___________________
Graphical Least Squares Regression Simulaneous
___________________
Methods Methods Method Equation Method
___________________
___________________ Figure 9.1: Types of Statistical Methods
___________________
Trend Projection Method
Demand forecasting by trend projection method is based on
analysis of past sales patterns. This method is based on the
assumption that future events are a continuation of the past. Thus,
historical data can be used to predict the future. In projecting
demand for a product, the trend method is applied to time series
data on sales. Firms can get time-series data on sales of a product
from their sales department. New firms can use necessary data
from the older firms of the same industry. Two methods are used
for trend projection based on the basis of time series data. These
methods are described below.
1. Graphical Method: The time series data on the variable (e.g.

sales) under forecast are used to fit a trend line graphically.
For example, the graph below shows the sale of passenger cars
in a country from 1985-2001. Based on the data of sales of
cars, a line or curve is drawn showing sale of passenger cars.
The line can be drawn for the period for which the data is
available. The actual movement of sales of passenger is shown
by dotted lines. The straight line represents the trend line. In
this figure the trend line shows on upward trend.
2. Least Square Method: The trend line can be projected for

knowing the future demand by two methods- linear trend and
exponential trend.
When the time series data shows a rising trend in the sales,
then a straight line trend equation of the following kind is
used.
S = a + bt
75
Notes
Trend
Line ___________________
Actual ___________________
Sales
Sales ___________________
($)
___________________
___________________
___________________
___________________
85 86 87 Time 01
___________________
___________________
Figure 9.2: The Graphical Method of Forecasting
___________________
Where S = annual sales, t = time (in years) a and b are
constants. The parameter b gives the measures of annual
increase in sales. The coefficients of a and b are estimated by
the following two equations:
ΣS = na + bΣΣt
ΣSt = aΣt + bΣL2
Where n is the number of time period (years). Solving such

equations can be learnt from the following example.
Example: Estimation of trend projection by using the linear

trend equation. Let us consider the following data of sales of
good* by a firm between 2009 and 2010.
Table 9.1
Year Sales of t t2 St
Good* ($)
1991 10 1 1 10
1992 12 2 4 24
1993 11 3 9 33
1994 15 4 16 60
1995 18 5 25 90
1996 14 6 36 84
1997 20 7 49 140
2008 18 8 64 144
2009 21 9 81 189
2010 25 10 100 250
N=10 ΣS=164 Σt=55 Σt2=385 ΣSt=1024

By substituting the values in the linear trend equation, we get
76
Notes S = na + bΣt
___________________ ΣSt = aΣt + bΣt2

___________________ 164 = 10a + 55b ...(1)
___________________
1024 = 55a + 385b ...(2)
___________________
By solving equations (1) and (2) we get S = 8.26 +1.48t
___________________
Now, we can use the above equation for projecting sales of good *
___________________
for the 11th year, 12th year, 13th year and so on.
___________________
11th year 2003, S03 = 8.66 +1.48(11) = 24540 units
___________________
12th year 2005, S04 = 8.66 +1.48(12) = 26020 units
___________________
___________________ 13th year 2005, S05 = 8.66 + 1.48(13) = 27500 units
When the sales (variable) have increased over the past years at an
increasing rate, then the appropriate trend equation to be used is
the exponential trend equation of the following form.
Y = aebT
Or Logey = log a + bT
Where y = sales, T=time and a and b are constants.
Barometric Method
Barometric forecasting, as conducted today, is primarily the result
of the work conducted at the national Bureau of Economic
Research (NBER) and Conference Board of U. S. The basic
approach of this technique is to construct an index of relevant
economic indicators.
Leading indicator
Coincident indicator
Indicator Level
(Value) Lagging indicator
0 Peak Date Trough Date Time
Figure 9.3: Business Cycle

Relative Positions of Leading, Coincident and
77
Lagging Indicators: The economic indicators are time-series
Notes
that may
1. Precede (lead) changes in the level of general economic ___________________
activity-Leading indicators, or ___________________
2. Move in step or coincide with movements in general economic ___________________

activity-Coincident indicators, or ___________________
3. Follow or lag movements in general economic activity- ___________________

Lagging Indicators. ___________________
The relative positions of leading, coincident and lagging indicators ___________________

in the business cycle are shown graphically in Figure 9.4. ___________________
The index of leading economic indicators is used to forecast or ___________________

anticipate short-term changes in economic activity or turning
___________________
points in business cycle. The leading economic indicators tend to
precede changes in the level of general economic activity, in the
same way as changes in the mercury in a barometer precede
changes in weather conditions.
It may be noted at the outset that the barometric technique was

developed to forecast the general trend in overall economic
activities. This method can nevertheless be used to forecast
demand prospects for a product, not the actual quantity expected
to be demanded. For instance, development and allotment of land
by the Delhi Development Authority (DDA) to the Group Housing
Societies (a lead indicator) indicates higher demand prospects for
cement, steel, bricks and other construction materials.
The time series of various indicators are selected on the basis of

the following criteria:
1. Economic significance of the indicator: the greater the

significance, the greater the score of the indicator.
2. Statistical adequacy of time-series indicators: a higher score is

given to an indicator provided with adequate statistics.
3. Conformity with overall movement in economic activities.
4. Consistency of series to the turning points in overall economic

activity.
5. Immediate availability of the series, and
6. Smoothness of the series.

78
Econometric Methods
Notes
The econometric models are increasingly used to forecast the firm’s
___________________
demand and sales of a commodity as well as many other economic
___________________ variables. The characteristic that distinguishes econometric
___________________ models from other forecasting methods is that they seek to identify
and measure the relative importance (elasticity) of the various
___________________
determinants of demand or other economic variables to be
___________________ forecasted. By attempting to explain the relationship being
___________________
forecasted, econometric forecasting allows the manager to
determine the optimal policies for the firm. This is to be contrasted
___________________ with the other forecasting techniques examined in this unit that
___________________ forecast demand, sales, or other economic variables on the basis of
their past patterns or on the basis of some leading indicator alone.
___________________
___________________ Econometric forecasting frequently incorporates or uses the best

features of other forecasting techniques, such as trend and
seasonal variations, smoothing techniques and leading indicators.
Econometric forecasting models range from single-equation models
of the demand that the firm faces for product to large multiple-
equation models describing hundreds of sectors and industries of
the economy. Although the concern here is with forecasting
demand for a firm’s product, macro forecasts of national income
and major sectors of the economy are often used as inputs or
explanatory variables in simple single-equation demand models of
the firm. Therefore, we discuss both types of forecasting in this
section.
1. Single-Equation Models: The simplest form of econometric

forecasting is with a single-equation model. The first step is to
identify the determinants of the variable to be forecasted. For
instance, in forecasting the demand for coffee, the firm will
usually postulate that demand (Q) is a function of or depends
on the price of coffee (P), consumers’ disposable income (I), the
size of population (N), the price of tea (Ps - a substitute), the
price of milk (Pc - a complement), and the level of advertising
by the firm (A). Thus, we can write the following demand
equation to be estimated:
Q =ao + a1P + a21 +a3N + a4Ps + a5 Pc + a6A + e … (9.1)
Once the model has been estimated (that is, the values of the
a’s determined) and evaluated, the firm must obtain
forecasted values of the independent or explanatory variables
of the model for the time period for which the dependent
variable is to be forecasted. Thus, to forecast Qt+ 1 (i.e., the
demand faced by the firm in the next period), the firm must 79
obtain the values for Pt+1, It+l, Nt+1, PSt+l, PCt+1 and At+1, By Notes
substituting these forecasted values of the independent ___________________
variables into the estimated equation, we obtain the
forecasted values of the dependent variable (Qt+1). The ___________________
forecasted value of the macroeconomic variables of the model ___________________

(Yt+1 and Nt+1) are usually obtained from the Government
___________________
agencies or from many private firms that specialize in making
___________________
such forecasts. The micro variables in the model not under the
control of the firm (PSt+1 and PCt+1) might be forecasted by ___________________
time-series analysis or smoothing techniques, and the firm ___________________
can experiment with various alternative forecasted values of
the independent policy variables (Pt+1 and At+1) under its ___________________
control. ___________________
2. Multiple-Equation Models: Although single-equation ___________________
models are often used by firms to forecast demand or sales,

economic relationships may be so complex that a multiple-
equation model may be required. This is particularly the case
in forecasting macro variables such as gross national product
(GNP) or the demand and sales of major sectors or industries.
Multiple-equation models may include only a few equations or
hundreds of them. To show how multiple-equation models are
used in forecasting, we start with a very simple three-
equation (9.2, 9.3, and 9.4) model of the national economy that
can be used to forecast GNP.
Ct = a1 + b1 GNPt + m1t … (9.2)
It = a2 + b2 pt-1 +, m2t … (9.3)
GNPt = Ct + It + Gt … (9.4)
Where C = consumption expenditures
GNP = gross national product in year t
I = investment
p = profits
G = government expenditures
U = stochastic disturbance (random error term)
t = current year
t - 1 = previous year
80 Variables Ct, It, and GNPt (the left hand variables) are called
Notes
endogenous variables. These are the variables that the model
___________________ seeks to explain or predict from the solution of the model.
Exogenous variables, on the other hand, are those determined
___________________
outside the model. In the above model, pt-1 and Gt are the
___________________ exogenous variables. Their values must be supplied from outside
___________________ the model in order to be able to estimate the model. When (as in
the above model) some of the endogenous variables also appear on
___________________
the right of the equals signs, this means that they both affect and
___________________ are in turn affected by the other variables in the model (i.e., they
___________________ are simultaneously determined).
___________________ Equations 9.2 and 9.3 are called structural (behavioural)

___________________ equations because they seek to explain the relationship between
the particular endogenous variable and the other variables in the
___________________
system. On the other hand, Equation 9.4 is a definitional
equation or an identity and is always true by definition. Note that
Equation 9.4 has no parameters or coefficients to be estimated. We
will see that, given the value of the exogenous variables pt-1 and Gt,
we can solve the system and estimate the values of the endogenous
variables. A change in the value of an exogenous variable will
affect directly the endogenous variable in the equation in which it
appears and indirectly the other endogenous variables in the
system. For instance, an increase in pt-l leads to a rise in It directly
(Equation 9.3). The induced increase in It then leads to an increase
in GNPt and, through it, in Ct as well.
Since the endogenous variables Ct, It, and GNPt of the system are
both determined by and in turn determine the value of the other
endogenous variables in the model we cannot use the ordinary
least-squares technique to estimate the parameters of the
structural equations (the a’s and the b’s in Equations 9.2 and 9.3).
More advanced econometric techniques are required to obtain
unbiased estimates of the coefficients of the model.
By assuming that these coefficients are correctly estimated by the

appropriate estimating technique, we can show how the above
simple macro model can be used for forecasting the values of the
endogenous variables. To do this, we substitute Equations 9.2 and
9.3 into Equation 9.4 (the definitional equation) and solve. This
will give an equation for GNPt that is expressed only in terms of pt-1
and Gt, (the exogenous variables of the system). Then by
substituting the values of pt (which is known in year t+1) and the
predicted or forecasted value of Gt+1 into the solved equation, we
get a forecast for GNPt+1. That is, substituting Equation 9.2 into
81
Equation 9.4, we get
Notes
GNP = a1 + b1GNP + It + Gt …(9.5)
___________________
By then substituting Equation 9.3 into 9.5, we get ___________________
GNPt = a1 + b1GNPt + a2+b2pt-1 + Gt ___________________
___________________
GNPt (1-b1) = a1 + a2 + b2pt-1 + Gt … (9.6)
___________________
Dividing both sides of Equation 9.6 by 1 – b1 we finally obtain
___________________
GNPt = (a1 + a2)/1- b1 + (b1πt-1)/1- b1 + Gt/1- b1 … (9.7) ___________________
Equation 9.7 is called a reduced-form equation because GNPt is ___________________

expressed only in terms of pt-1 and Gt (the exogenous variables of
___________________
the model). By substituting into Equation 9.7 the value of pt
___________________
(which is known in year t + 1) and the predicted value of Gt+1, we
obtain the forecasted value for GNPt+1. The reduced-form equations
for Ct and It can similarly be obtained.
While the above simple macro model contains three endogenous

and two exogenous variables, and two structural and one
definitional equations, most large models of the economy
contain hundreds of variables and equations. They require
estimates of tens, if not hundreds, of exogenous variables and
provide forecasts of an even greater number of endogenous
variables, ranging from GNP to consumption, investment, and
exports and imports by sector, as well as for numerous other
real and financial variables. Firms usually obtain macro
forecasts for the entire economy and its major sectors from firms
specializing in making such forecasts and use these macro-
forecasts as inputs in their own specific forecasting of the
demand and sales of the firm’s product(s).
Check Your Progress
Fill in the blanks:
1. ................... seek to explain the relationship between
the particular endogenous variable and the other
variables in the system.
2. ................... is an identity and is always true by
definition.
82
Summary
Notes
Techniques of demand forecasting depend upon information on
___________________
three questions:a. What do people say? b. What do people do? c.
___________________ What have people done?
___________________
In consumers’ opinion survey buyers are asked about their future
___________________ buyingintentions of products, their brand preferences and
___________________ quantities of purchase.
___________________ Future demand level may also be ascertained by experts with the
help of brainstorming or by structured discussions or even by
___________________
discussing without face to face interaction.
___________________
Demand forecasting may also be done by market experiments
___________________
conducted under controlled or simulated conditions or in real
___________________ markets in which consumers actuallybuy a product without the
awareness of being observed.
Lesson End Activity

Give an example of the demand forecasting done by the barometric
method.
Keywords
Graphical Method: The time series data on the variable (e.g.
sales) under forecast are used to fit a trend line graphically.
Least Square Method: The trend line can be projected for
knowing the future demand by two methods- linear trend and
exponential trend.
Single-Equation Models: The simplest form of econometric
forecasting is with a single-equation model.
Multiple-Equation Models: Although single-equation models are
often used by firms to forecast demand or sales, economic
relationships may be so complex that a multiple-equation model
may be required.

1. Explain the barometric method of demand forecasting.
2. Describe the Econometric method of forecasting.“The concept
of elasticity of demand and demand forecasting are versatile
tools of economic analysis”. Discuss the validity of this 83
statement. Notes
3. “The concept of elasticity of demand and demand forecasting ___________________

are versatile tools of economic analysis”. Discuss the validity of ___________________
this statement.
___________________
___________________
Further Readings
___________________
Books ___________________
Managerial Economics by Christopher R Thomas, S Charles ___________________

Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education. ___________________
Miller. R.E., and P.D. Blair: Input and Output Analysis; ___________________
Foundations and extensions (Englewood Cliffs., N.J.: Prentice Hall,
___________________
1985).
Granger, C.W.: Forecasting in Economics and Business (New York:

Academic Press, 1989).
Himilton, J.D.: Time Series Analysis (Princeton, N.J. Princeton

University Press, 1994).
Salvatore, Dominick: Microeconomic Theory and Applications, 3rd

Ed (Reading, Mass, Addison Wesley, 1997).

Publication.
Web Readings
en.wikipedia.org/wiki/Demand_forecasting
84
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 11: Supply Analysis
Unit 9
91
Notes
Supply Analysis
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Supply Function ___________________

\ The Law of Supply ___________________
\ Determinants of Supply
___________________
___________________
Introduction
___________________
A detailed review of the inputs and outputs of a process that is
employed to assess how the available quantity of a product is affected
by changes in demand, input factors and production techniques.
Supply analysis is often used to make key policy decisions by
manufacturing business managers since it gives them insight into
how shifts in production are likely to influence market 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 selling a higher
quantity at a higher price increases revenue.
Supply Function
Supply of a good or service refers to the quantities that the seller(s)

is willing to and able to offer for sale at various prices within a
given time period, other factors held constant. The foregoing
discussion on production and cost analysis and the objectives of the
firm have thrown light on the determinants of supply. The amount
of a good supplied depends on a number of factors that can be
stated in terms of a supply function as follows.
Sx = f (Px, Py, C, T, O, F, W, N)
1. Product Price (Px): The quantity supplied varies directly to

price of the good, other factors held constant. Generally,
92
producers tend to supply more at a higher price to earn
Notes
Activity greater profits. Higher revenues from sales are necessary to
What are the factors of the
___________________ induce producers to increase supply of a good or service.
supply function?
___________________ 2. Prices of Related Products (Py): Just as from consumer’s
___________________ standpoint, substitutes or complements influence demand for
a good or service, so also prices of goods related in production
___________________
influence firm’s supply goods and services. For example,
___________________ suppose the sellers of pizza notice that the price of hot dogs
___________________ increases substantially. They may reduce the amount of
resources devoted to the selling of pizza in favour of hot dogs.
___________________
This will decrease the supply of pizza. If the sellers were
___________________ already selling two (or more) goods, the change in market
___________________ conditions would prompt them to reallocate their resources
towards the more profitable ones.
___________________
The price of a complementary good is expected to affect the

supply of the good under consideration in a direct manner. For
instance, if the price of computer hardware increases, other
things remaining constant, the supply of software would
increase and vice versa. This is due to the reason that, an
increase in price of computer hardware increases its supply
that results in an increase in supply of software.
3. Costs and Technology (C and T): The two factors can be

treated as one as they are closely related. Costs refer to the
cost of factors used in production. Increase in factor prices,
other things remaining constant, increases production cost
that leads the firm to restrict supply. For instance, an
increase in price of color picture tubes (CPT) will increase the
price of CTVs.
Technology refers to technological innovations or

improvements introduced to reduce the unit cost of production
or increase factor productivity. A reduction in total cost lowers
the total cost curve which leads to an increase in supply.
4. Objectives of the Firm (O): The amount of a good or service

supplied is influenced by the objectives of the firm. For
instance, a sales maximiser would supply more than the profit
maxi miser to gain greater market share.
5. Future expectations (F): Like consumers’ expectations

influence their demands, sellers’ expectations influence
supply. Future expectations of prices, costs, sales and the
general macroeconomic conditions influence supply. For 93
example, if sellers anticipate a rise in price, they may choose Notes
Activity
to hold back current supply to take advantage of the higher State the law of supply.
___________________
prices in future, thus decreasing market supply. A likely glut
___________________
in future would have a reverse impact. Similarly, sellers’
expectations of change in future production costs in ___________________
comparison to current input prices would influence their ___________________
current supplies. A shortage of raw materials in future may
___________________
restrict supply and vice versa.
___________________
6. Weather conditions and other short-term factors (W):
Floods, droughts, strikes, lockouts and other short-term factors ___________________
have adverse temporary impact on supply. ___________________
Supply of geysers and room heaters tends to increase in ___________________
winters, as there are few buyers in other months and carrying ___________________
costs of inventory. Floods and droughts will reduce supply of
agricultural goods. Similarly, strikes and lockouts have
negative effect on supply of industrial goods.
7. Number of sellers (N): The number of sellers has a direct
impact on supply. The more sellers, the greater is the market
supplies. If sellers are in collusion, they would tend to restrict
supply. Sellers under rivalry are most likely to increase supply
to capture larger market share.
Check Your Progress

Fill in the blanks:
1. The quantity supplied varies ................... to price of the
good, other factors held constant.
2. ................... refer to the cost of factors used in
production.
3. ................... refers to technological innovations or
improvements introduced to reduce the unit cost of
production or increase factor productivity.
The Law of Supply

The law of supply states that quantity supplied is related directly
to its price, other factors held constant. That is, as the price of a
good or service increases, its supply expands, and contracts with a
decrease in price. (Note that the law depicts relation only between
the supply of the good or service and its price, while other
94
determinants are taken as constant). This is so for the reason that,
Notes
firstly, a higher price generally implies higher profits that induces
___________________ the producers to supply more. Secondly, new producers may enter
___________________ the industry due to higher profits leading to an increase in
production and supply. The law can be shown in form of a supply
___________________
schedule and supply curve.
___________________
A supply schedule depicts various quantities of a good or service
___________________
the firm will sell at different prices at a given point of time. Market
___________________ supply or industry supply is the aggregate of supply of individual
___________________ firms at different prices. Table 11.1 shows firm and market or
industry supply schedules for A grade newsprint.
___________________
___________________
Supply curve is a diagrammatic representation of supply schedule.
It shows the maximum amount of a good the firm is willing to sell
___________________
at each possible price of a good. Figure 11.1 depicts the market
supply curve of newsprint.
Table 11.1: Market Supply of Newsprint
Price (`/kg.) Firm A Firm B Market Supply

(A + B)
10 50 0 50
20 130 100 230
30 120 230 350
40 200 300 500
50 250 350 600
Figure 11.1: Market Supply of Newsprint

95
Check Your Progress
Notes
Activity
Fill in the blanks:
Graphically depict
___________________ the
1. A ................... depicts various quantities of a good or movement and shift in supply.
___________________
service the firm will sell at different prices at a given
point of time ___________________
2. ................... is a diagrammatic representation of supply ___________________

schedule. ___________________
___________________
Movements and Shift in Supply
___________________
As we have movements and shifts in demand so also there are
___________________
movements and shifts in supply.
___________________
1. Changes in price result in changes in the quantity supplied.
These are called as movements along a supply curve. The ___________________
quantity supplied expands with an increase in price as shown

by a movement from B to B2 along supply curve S in
Figure11.1. On the other hand, at a lower price contraction of
supply takes place depicted by a movement along supply curve
S from B to B1.
2. Changes in non-price determinants result in changes in the

supply. Shifts in the supply curve represent such shifts.
Increase in supply is shown by a downwards shift in the
supply curve to the right, while a decrease in supply by a shift
in the supply curve to the left. In Figure 11.1, though the price
is constant, an increase in supply shifts the supply curve from
S to S1 thereby increasing supply from PB to PC. The supply
curve S2 shows a decrease in supply from PB to PA as an effect
of non-price determinants.
Check Your Progress

Fill in the blanks:
1. ................... is shown by a downward shift in the supply
curve tyo the right, while a decrease in supply by a shift
in the supply curve to the left.
2. Changes in price result in changes in the quantity
supplied are known as ...................
96
Elasticity of Supply
Notes
Elasticity of supply is the degree of responsiveness of quantity
___________________
supplied to a given change in price. It can be stated as follows:
___________________
Proportionate change in quantity supplied
___________________ Es =
Proportionate change in price
___________________
ΔQ/Q
___________________ Es =
ΔP/P
___________________
In case of zero elasticity or perfectly inelastic supply the quantity
___________________
supplied remains fixed irrespective of changes in price as shown by
___________________ supply curve S1 in Figure 11.2. In case of consumer perishables like
___________________ milk, supply remains almost fixed as they have to be sold at
whatever price they can fetch. Infinite elasticity (S2) is another
___________________
extreme case where nothing is supplied at lower prices. Figure 11.2
depicts that the producers are willing to supply any amount at
price OP but nothing below it.
Price
S 1 (Es = 0)
S 5 (Es < 1)
S3 (Es = 1)
P S 2 (Es = Infinity)
S 4 (Es > 1)
O Q
Quantity
Figure 11.2: Elasticity of Supply

Supply curve S3 depicts elastic supply which shows that the supply
changes in same proportion as the change in price.
Any straight line passing from the origin, irrespective of its slope
has unit elasticity. Supply is said to be elastic when the quantity
supplied changes more than proportionately to the change in price.
When the supply curves cuts the vertical axis it is relatively elastic
as shown by S4. On the other hand, if the change in price leads to a
less than proportionate change in quantity supplied, the supply
tends to be inelastic. The supply curve cutting the horizontal axis
like S5 is inelastic.
Managerial Uses of Supply Elasticity 97
Activity
Notes
The concept of supply elasticity explains why a given change
List the various managerial
in price tends to have greater effect on the amount supplied uses___________________
for elasticity of supply.
as one moves from a market period (very short time period) ___________________
to a short-run and finally to a long run. The supply in the ___________________
market period tends to be perfectly inelastic as the use of
___________________
any input cannot be changed readily. In short run, some
___________________
factors of production can be changed; therefore, supply
is relatively elastic. As in the long run use of all factors can ___________________
be changed, the supply curve in the long run, is highly elastic. ___________________
For this reason, elasticity of supply helps to make ___________________

adjustments in supply to a higher price in the long run. ___________________
___________________
Check Your Progress
Fill in the blanks:
1. ................... depicts elastic supply which shows that the
supply changes in same proportion as the change in
price.
2. Any straight line passing from the origin, irrespective
of its slope has ................... elasticity.
3. Supply is said to be elastic when the quantity supplied
changes more than proportionately to the change in
...................
Summary
Supply of a good or service refers to the quantities that the seller(s)
is willing to and able to offer for sale at various prices within a
given time period, other factors held constant. Elasticity of supply
is the degree of responsiveness of quantity supplied to a given
change in price.
Lesson End Activity

Give an example of supply for any product and give the graphical
representation of the supply for that product.
98
Keywords
Notes
Costs: It refers to the cost of factors used in production.
___________________
___________________ Product Price: The quantity supplied varies directly to price of

the good, other factors held constant.
___________________
___________________ Technology: It refers to technological innovations or

improvements introduced to reduce the unit cost of production or
___________________
increase factor productivity.
___________________
___________________
___________________
1. Discuss the shape of supply curve.
___________________
2. Describe the supply function.
___________________
3. Describe the factors affecting the supply.
4. Explain the concept of technological progress.
Further Readings
Books
Maurice- Special Indian, 8th Ed, Mc-Graw Hill Education.
Publication
Web Readings
en.wikipedia.org/wiki/Production_function
economicsconcepts.com/production_function.htm - United States
www.jeffsims.net/flash/production.html
UNIT 19: Pricing Methods
Unit 10
179
Notes
Pricing Methods
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
\ Concept of Pricing ___________________

\ Methods of Pricing ___________________
\ Multi-product Pricing
___________________
___________________
Introduction
___________________
The microeconomic principle of profit maximisation suggests
pricing by the marginal analysis that is by equating MR to MC.
However, in the pricing methods followed in practice, firms rarely
follow this process. Uncertainty with regard to demand and cost
functions and the deviation from the objective of short run profit
maximisation are the two main reasons for this.
Determination of profit maximisation requires an accurate
knowledge of the demand and cost conditions facing the firm. It is
not easy to get a good estimate of the true demand function, for one
faces difficulties with regard to the specification of the function,
data availability and limitations of the estimation method.
Besides, there is a problem of product interdependence among rival
firms, which is rather significant in an oligopolistic market.
Similar problems are witnessed with regard to the cost function.
There is no unique theory of firm behaviour. Profit is certainly an
important variable for which every firm cares, but maximisation of
short run profit is not a popular objective of the firm today. Firms
seek maximum profit in the long run. The problem is dynamic and
its solution requires accurate knowledge of demand and cost
conditions over time, which may be impossible.
In view of these problems, economic prices are a rare phenomenon.
Instead, firms set prices for their products through several
alternative means which are being discussed below.
Multi Product Pricing

Most modern firms produce a variety of products rather than a
single product. This requires that we expand our simple pricing
180
rule and consider demand and product interdependencies.
Notes Normally in the case of a firm which is producing multiple
___________________ commodities, the demands for its various products are separable
but the costs are not quite divisible, product-wise. Thus, while
___________________
there are separate demand functions for all products of a multiple
___________________ product firm, there is only one cost function for all products. In the
livestock industry, meat and wool are produced together where
___________________
sheep are reared. Crude oil and natural gas may be found together
___________________ in oil exploration. In these joint products, costs also are joint. In
___________________ most cases, joint products come in fixed proportions.
___________________ In joint products, the profit maximizing prices will be given by the
point at which the combined marginal revenue of the products
___________________
equals the marginal costs as shown in Figure 19.1.
___________________
The line CMR denotes the combined marginal revenue. It is
___________________ obtained by summing MR1 and MR2 vertically. The CMR equals
MC at point E. A horizontal line passing through point E
determines the prices and quantities of the two commodities. It is
assumed that the demand functions of different commodities are
independent of one another. The profit-maximizing prices are OP1
and OP2 and the quantities are OQ1 and OQ2 of commodities 1 and
2 respectively. The prices in the case of more than two joint
products can also be determined in the same manner.
Figure 19.1
Price Discrimination
Price discrimination occurs when variation in prices for a product
in different markets does not reflect variation in costs. It is
designed to increase the total profit. Three conditions must be
fulfilled before a firm successfully practises price discrimination.
a. The firm must have at least some control over price.
b. It must be possible to group different markets in terms of the
price elasticity of demand in each.
181
c. The firm's markets must be separable, meaning that products
Notes
cannot be purchased in one market and then resold in
another. ___________________
___________________
Generally, price discrimination is identified to be of the following
three types. ___________________
___________________
First Degree Discrimination
___________________
This type of discrimination involves charging the maximum price
___________________
possible for each unit of output. Figure 19.2 shows the demand
curve of a monopolist. The curve indicates the maximum price that ___________________
can be obtained for successive units of output. For example, the ___________________
first unit Q1 can obtain maximum price P1 and so on. It is assumed
___________________
that marginal cost is constant and equal to average cost.
___________________
First degree price discrimination charges the maximum price
possible for each unit of output. The consumer willing to pay the
highest price P1 is identified and so on for P2, P3, etc. The profit
maximizing output rate is where the marginal cost and demand
curves intersect (QD). The maximum price that can be obtained for
the product is just equal to the marginal cost of production at QD.
Selling more than QD units would reduce profits because price
would be less than marginal cost, and vice versa. This type of
discrimination is most profitable scheme for a firm and also the
most extreme form. It is, however, not common because it requires
complete knowledge of the market demand and willingness of
consumers. A possible example may be selling of government bonds
by asking buyers to submit tenders.
Figure 19.2
182
Second Degree Discrimination
Notes
Instead of setting different prices for each unit, here pricing is
___________________
done on the basis of quantities of output purchased by individual
___________________ consumers. For each buyer, refer Figure 19.3, the first Q1 units
purchased are priced at P1, the next Q2 – Q1 units are priced at P2
___________________
and all additional units are priced at P3. Examples are found in
___________________
cases where services are metered, e.g., electricity, telephone, gas,
___________________ second refills of food items, etc.
___________________
___________________
___________________
___________________
___________________
Figure 19.3
Third Degree Discrimination

This is the most common type. It separates consumers or markets
on the basis of their price elasticity of demand. This segmentation
may be based on factors like geographic separation of markets,
nature of use (business, residential), personal characteristics of
consumers (age - adult and child), etc.
Figure 19.4 shows the marginal revenue curves of two individual

markets as MR1 and MR2. It is assumed that the marginal costs
are equal and constant in both. The combined demand curve of the
two is the sum of the demands in each of the markets at each price.
Similarly the marginal revenue curve is the sum of two individual
curves. The optimal total output is at point QT where MRT = MC.
P Market-I P Market-II P Combined Market
P1 P2
D2
D1 DT
e1 MC e2 MC MC
MR2 MRT
MR1
O Q O Q O Q
Q1 Q2 QT
Figure 19.4
Since marginal costs are constant, the decision rule for allocating
183
output is that the marginal revenue should be equal in the two
markets. Thus, the extra revenue obtained from selling an Notes
additional unit in the first market should be the same as that ___________________
received from selling one more unit in the second market. If
___________________
the two are not equal, the firm could increase its revenue and
profit by allocating additional output to the market with greater ___________________
marginal revenue. Thus Q1 units of output should be sold at a ___________________
price of P1 in market 1 and Q2 units at price of P2 in market II. A
___________________
higher price is charged in market 1, where demand is relatively
less elastic. The consumers here are thus, less sensitive to price, ___________________
i.e. higher prices can be charged.
___________________
International Price Discrimination and Dumping ___________________
International price discrimination is called dumping or ___________________
even persistent dumping. Under this type of dumping the ___________________

monopolist sells the commodity at a higher price at home. The
reason is that the market demand curve may be less elastic at
home. The price is less abroad where the monopolist faces
competition from other nations and the market demand curve
for the monopolist's product is more elastic. Predatory dumping
is the temporary sale of a commodity at below cost or at a lower
price abroad in order to drive foreign producers out of business,
after which prices are raised abroad to take advantage of the
newly acquired monopoly power.
Sporadic dumping is the occasional sale of the commodity at below

cost or at a lower price abroad than in the domestic market in
order to unload an unforeseen and temporary surplus of
a commodity without having to reduce the domestic prices.
However, it is often difficult to determine the type of dumping and

domestic producers invariably demand protection against any form
of dumping.
Check Your Progress

Fill in the blanks:
1. ................... is the practice of selling two or more
products together for a single price.
2. ................... occurs when variation in prices for a
product in different markets does not reflect variation
in costs.
184
Pricing Methods in Practice
Notes
Activity
What are the three types of
In the practical market, different types of pricing methods are
___________________
cost-based pricing methods? followed. The common ones are discussed below:
___________________
___________________
Cost Based Pricing Methods
___________________ Cost based pricing methods have three types: Full cost or break-
even pricing, cost plus pricing and the marginal cost pricing. In full
___________________
cost pricing, price just equals the marginal (total) cost. In the
___________________ second type, some mark up is added to the average cost in arriving
at the price. In the last type, price is set equal to the marginal cost.
___________________
Cost oriented pricing is quite popular. It has several strengths as
___________________ well as limitations. Its strengths are its simplicity, acceptability
___________________ and consistency with a target rate of return on investment and the
price stability in general. Its limitations are difficulties in getting
___________________
accurate estimates of cost, particularly of the future cost rather
than the historic cost, volatile nature of the variable cost, and its
ignoring of the demand side of the market completely.
Penetration Pricing
While introducing new products or entering a new market, firms
may deliberately set a relatively lower price in the hope of
"penetrating" into the market. The motive is to establish market
share first and then gradually move to a more profitable price.
This requires that the demand be highly price elastic and the
nature of product differentiation be such that many consumers are
in a position to get attracted by the low price.
Penetration pricing is the reverse of the skimming policy in which

the price is lowered only as short run competition forces it.
The passive skimming policy has the virtue of safeguarding some

profits at every stage of market penetration. But it prevents quick
sales to the many buyers who are at the lower end of the income
scale or the lower end of the preference scale and who, therefore,
are willing to pay any substantial premium for product or
reputation superiority. The active approach in probing possibilities
for market expansion by early penetration pricing requires
research, forecasting and courage.
A decision to price for market expansion can be reached at various

stages in a product's life cycle: before and at birth, in childhood, in
adulthood or in senescence. The chances for large volume sales
should at least be explored in the early stages of product
development research, even before the pilot stage, perhaps with a
more definitive exploration when the product goes into production
and price and distribution plans are decided upon. And the
185
question of pricing to expand the market, if not answered earlier,
Notes
will probably arise once more after the product has established an
elite market. ___________________
___________________
Quite a few products have been rescued from premature
renascence by pricing them low enough to tap new markets. The ___________________
reissues of important books in the low-priced pocketbook category ___________________
illustrate this point particularly well. These have produced not
___________________
only commercial but intellectual renascence as well to many
authors. The pattern of sales growth of a product that had reached ___________________
stability in a high price market has undergone sharp ___________________
changes when it was suddenly priced low enough to tap new
___________________
markets.
___________________
The following conditions generalize and indicate the desirability of
an early low-price policy: ___________________
z A high price elasticity of demand in the short run, i.e. a high

degree of responsiveness of sales to reductions in price.
z Substantial savings in production costs as the result of greater

volume - not a necessary condition, however, since if elasticity
of demand is high enough pricing for market expansion may
be profitable without realizing production economies.
z Product characteristics such that it will not seem bizarre

when it is first fitted into the customer's expenditure pattern.
z A strong threat of potential competition.
This threat of potential competition is a highly persuasive reason

for penetration pricing. One of the major objectives of most low-
pricing policies in the pioneering stages of market development is
to raise entry barriers to prospective competitors.
Price Skimming
This is also a variation of price discrimination, not over two
markets, but over a period of time. The firm starts with a high
price for customers who are willing to pay for a better quality or
prestige value. The price is gradually decreased or "skimmed" to
increase the number of customers. But there is danger in letting
the price drop beyond a point because of the perceived correlation
between quality and price. Firms quite often do not undertake such
tactics and set the desirable price straight away on some other
basis.
186
Notes For products that represent a drastic departure from accepted
ways of performing a service, a policy of relatively high prices
___________________
coupled with heavy promotional expenditures in the early stages of
___________________ market development and (lower prices at later stages) has proved
___________________ successful for many products. There are several reasons for the
success of this policy:
___________________
z Demand is likely to be more inelastic with respect to price in
___________________
the early stages than it is when the price is fully grown. This
___________________ is particularly true for consumer goods. A novel product such
___________________ as the electric blanket is not yet accepted as a part of the
expenditure pattern, consumers are still ignorant about its
___________________
value compared to conventional alternatives. Moreover, at
___________________ least in the early stages, the product has so few close rivals
___________________ that cross elasticity of demand are low.
z Launching a new product with a high price is an efficient

device for breaking up the market into segments that differ in
price elasticity of demand. The initial high price serves to
skim the cream of the market that is relatively insensitive to
price. Subsequent price reductions tap successively more
elastic sectors of the market. This pricing strategy is
exemplified by the systematic succession of editions of a book,
sometimes starting with a high priced limited personal edition
and ending up with a low-price pocketbook.
This policy is safer, or at least appears so. Facing an unknown

elasticity of demand, a high initial price serves as a "refusal"
price during the stage of exploration.
z Many companies are not in a position to finance the product

floatation out of distant future revenues. High cash outlays in
early stages result from heavy costs of production and
distributor organizing, in addition to the promotional
investment in pioneer product. High prices are a reasonable
financing technique for shouldering these burdens in the light
of many uncertainties about the future.
Loss Leader Pricing

Suppose a firm produces a high value item, X, which requires a low
value but high volume item Y, and also produces Y. The sale of X is
less than Y but use of Y is more (e.g., X-razor, Y-blades). Thus the
loss on X can be more than compensated by sale of Y if the firm is
able to produce both the part and consumable in right proprietary
or dedication. So the customer does not buy the replacements from
UNIT 19: Pricing Methods
another competitor. Thus the so-called loss-leader is really a profit 187

leader and the firm gets profit after its total sale. Notes
___________________
Transfer Pricing
___________________
It refers to the determination of the price of the intermediate
___________________
products sold by one semiautonomous division of the same firm. It
is essential in determining the optimal output of each division and ___________________
of the firm as a whole and in evaluating divisional performance
___________________
and determining divisional rewards. The correct transfer price for
an intermediate product for which there is no external market is ___________________
the marginal cost of production. When a perfectly competitive ___________________

external market for the intermediate product exists, the transfer
___________________
price for intracompany sales of the intermediate product is given
by the external competitive price for the intermediate products. ___________________
When an intermediate product can be sold in an imperfectly ___________________
competitive market, the transfer price of the intermediate product
is given at the point where the net marginal revenue of the
marketing division of the firm is equal to the marginal cost of the
production division at the best total level of output of the
intermediate product and the price charged in the external market
is given on the external demand curve.
Ramsey Pricing
A firm's common costs are those that cannot be assigned to any
single product or service. The use of fully distributed costs can lead
to poor pricing decisions. A product can be profitably produced if its
price exceeds incremental costs of supplying the product. Ramsey
pricing is the second best alternative that can be used when
marginal cost pricing is not feasible. A simple version of Ramsey
pricing specifies that price deviations from marginal cost should be
inversely related to the elasticity of demand. The reason is that if
demand is elastic, increasing the price causes a substantial
reduction in the quantity demanded.
Peak-Load Pricing
Peak-load pricing can be used to reduce costs and increase profits
if the same facilities are used to provide a product or service at
different periods of time, the product or service is not storable or
the demand characteristics vary from period to period. The theory
of peak-load pricing suggests that peak period users should pay
most capacity costs, while off-peak users may be required to pay
only variable costs. An example is followed in pricing of telephone
services.
188
Product Bundling
Notes
Bundling is the practice of selling two or more products together
___________________
for a single price. When the products are only available as a
___________________ package, the pricing strategy is referred to as pure bundling. If at
least some products can also be purchased separately, then the
___________________
firm is using mixed bundling. Examples are complete meals offered
___________________ in some restaurants, cars sold with air conditioners, antilock
___________________ brakes, cassette decks at "no-extra" price, season-tickets packages
with ticket for a popular game and a not so popular one, etc. Some
___________________
advantages of product bundling which has made it a common
___________________ practice are:
___________________ z Firms can reduce their production and marketing costs by
___________________ packaging goods and services in this way,
___________________ z It allows firms to increase their profits by extracting

additional consumer surplus,
z It requires less information about tastes and preferences of

customers.
Prestige Pricing and Psychological Pricing

A perception on the part of the firm or producer that charging a
higher price will increase the quantity of the product sold because
of the prestige achieved by the customer, is known as prestige
pricing. The basis for this seeming contradiction is that either the
customers are not well informed about the quality of the various
products or that the producer has succeeded in creating a special
snob appeal for its product.
The practice of charging ` 9.95/- or ` 9.99/- instead of ` 10/- for a

product in the belief that such pricing will create the illusion of
significantly lower price to the customer is referred to as
psychological pricing. However, this may be a temporary
phenomenon with most consumers, and over an extended period of
time such pricing would appear to have limited application.
Value Pricing
Value pricing refers to the selling of quality goods at much lower
prices than previously. This is an old fashioned price-cutting but
with manufacturers redesigning the product to keep or enhance
quality while lowering costs so as to still earn a profit. It is actually
offering more for a lot less. Value pricing is likely to spread in the
future as companies cater to increasingly sophisticated but bargain
conscious consumers.
Government's Control on Pricing
The government has from time to time introduced price control for 189
certain commodities. Two categories of commodities have Notes
been brought under price control. Necessities of various kinds
___________________
such as edible oils, drugs and textiles fall into the first
category. The second category consists of certain basic goods ___________________
such as cement and steel which are intermediate inputs in the ___________________
production of other commodities. The Tariff Commission of
India and the Bureau of Industrial Costs and Price (BICP) ___________________
have been involved in determining fair prices for commodities ___________________

under price control.
___________________
This approach to price fixation has led to a great deal ___________________
of controversy in India. Questions have been raised as to
what constitutes a reasonable rate of return. The argument is ___________________
that the rates of return assumed by the Tariff Commission ___________________

and similar price fixing agencies fall below what investors
___________________
would consider reasonable. As a result, it is claimed that
resources may not flow into industries under price control,
thereby impairing the long run interests of consumers. If
excess demand conditions exist, contradiction of supply of
the goods in question will have an adverse effect on
consumer interests. Price control calls for a careful balancing
of the interests of consumers and producers, which is an
inherently difficult task to perform.
Check Your Progress
Fill in the blanks:
1. In ..................., the selling of quality goods at much
lower prices than previously.
2. ................... can be used to reduce costs and increase
profits if the same facilities are used to provide a
product or service at different periods of time, the
product or service is not storable or the demand
characteristics vary from period to period.
3. ...................refers to the determination of the price of
the intermediate products sold by one semiautonomous
division of the same firm.
4. A perception on the part of the firm or producer that
charging a higher price will increase the quantity of the
product sold because of the prestige achieved by the
customer, is known as ...................
190
Summary
Notes
There is no unique theory of firm behaviour. Profit is certainly an
___________________
important variable for which every firm cares, but maximisation of
___________________ short run profit is not a popular objective of the firm today. Firms
___________________ seek maximum profit in the long run. The problem is dynamic and
its solution requires accurate knowledge of demand and cost
___________________
conditions over time, which may be impossible.
___________________
In view of these problems, economic prices are a rare phenomenon.
___________________
Instead, firms set prices for their products through several
___________________ alternative means like price discrimination, different pricing
___________________ methods or techniques etc.
___________________
Lesson End Activity
___________________
List the various pricing methods and find out how they are used in
practice.
Keywords
Product Bundling: Bundling is the practice of selling two or more
products together for a single price.
Price Discrimination: Price discrimination occurs when
variation in prices for a product in different markets does not
reflect variation in costs. It is designed to increase the total profit.
Value Pricing: The selling of quality goods at much lower prices
than previously.
Prestige Pricing: A perception on the part of the firm or producer

that charging a higher price will increase the quantity of the
product sold because of the prestige achieved by the customer, is
known as prestige pricing.
Peak load Pricing: Peak-load pricing can be used to reduce costs
and increase profits if the same facilities are used to provide a
product or service at different periods of time, the product or
service is not storable or the demand characteristics vary from
period to period.
Transfer Pricing: It refers to the determination of the price of the
intermediate products sold by one semiautonomous division of the
same firm.
Cost plus Pricing: Some mark up is added to the average cost in
arriving at the price.
Questions for Discussion 191
Notes
1. State and explain the factors which you would normally
___________________
consider while pricing a new product.
___________________
2. We can apply the equi-marginal principle in the context of
multi-product pricing. True or False. Explain. ___________________
3. Explain the principles involved for the success of price ___________________
discrimination. Do you think that price discrimination is anti- ___________________

social?
___________________
4. A seller sells his commodity in two markets I and II and their ___________________
demand schedules are as follows:
___________________
Market I Market II
___________________
Px Dx Px Dx ___________________
10 80 12 120
8 120 10 160
6 180 8 220
4 200 6 280
The seller wants to maximize profits by selling just 280 units.

What prices will he set in the two markets?
5. Given two isolated markets supplied by a single monopolist,

the two corresponding demand functions being
P1=12–Q1 and P2=20–3Q2
Suppose the total cost function for the monopolist is

C=3+2(Q1–Q2)
What will prices, sales and marginal revenues be in the two

markets, under regime of price discrimination and what profit
will the monopolist earn?
Further Readings
Books
Grubel, Harbert G (1977); International Economics (Homewood).
S K Agarwala, Microeconomics, First Edition, New Delhi, 2007

192
Notes Managerial Economics by Atmanand, 2nd Edition, Excel Books
Publication
___________________
___________________
___________________
___________________
Web Readings
___________________ en.wikipedia.org/wiki/Pricing
___________________ www.stat.fi/voorburg2005/kenessey_1.pdf
___________________
www.norcron.com/documents/pricing_methods.pdf
___________________
www.sedi.org/DataRegV2-unified/capnet.../pricing% 20methods.pdf
___________________
___________________
UNIT 22: Break-even Analysis
Unit 11
207
Notes
Break-even Analysis
___________________
___________________
___________________
Objectives
___________________
topics: ___________________
Break-even analysis ___________________

Uses of break-even analysis ___________________
Limitations of break-even analysis
___________________
___________________
Introduction
___________________
Break-even analysis is a technique widely used by production
management and management accountants. It is based on
categorising production costs between those which are "variable"
(costs that change when the production output changes) and those
that are "fixed" (costs not directly related to the volume of
production).
Total variable and fixed costs are compared with sales revenue in
order to determine the level of sales volume, sales value or
production at which the business makes neither a profit nor a loss
(the "break-even point").
Concept of Break-even Analysis

Break-even analysis or profit contribution analysis is a technique
used to make managerial decisions with regard to relation between
total revenue (TR), total costs (TC) and total profits. It is often
used by managers to determine the sales volume required for the
firm to break even and to assess the total profits and losses at
various levels of sales.
Assumptions
The break even analysis is based on certain assumptions, namely.
ven All costs are either perfectly variable or absolutely fixed over the
entire period of production but this assumption does not hold well
in practice.
208
The volume of production and the volume of sales are equal; but in
Notes
Activity reality they differ.
Explain linear break-even
___________________
analysis. All revenue is perfectly variable with the physical volume of
___________________ production and this assumption is not valid.
___________________
The assumption of stable product mix is realistic.
___________________
Linear Break-even Analysis
___________________
Figure 22.1 (a) shows a linear break even relationship. The vertical
___________________
axis depicts total revenues and total costs whereas output is shown
___________________ on the horizontal axis. The slope of the TR curve refers to the
___________________ constant price of ` 10 per unit at which the firm can sell its output.
The TC curve indicates the total fixed costs (TFC) of ` 200 (the
___________________
vertical intercept) and a constant AVC of ` 5 (the slope of the TC
___________________ curve).
TR (a) Linear TR (b) Non linear

TC TC TC
TR B TR
Profit Profit
TC
400
B A
300 Loss
Loss TFC TFC
0 O
40 Q1 Q2 Q3
Quantity Quantity
Figure 22.1: Break-even Analysis
Total cost curve is a straight line because AVC is taken as

constant. Since AVC is constant, the extra cost of extra unit must
be constant too and equal to AVC. This is often the case for many
firms for small changes in output or sales. The firm breaks even at
40 units of output (point B) where TR is equal to the TC. The firm
incurs operating losses at smaller outputs (since TC > TR) and
earns operating profits at higher output levels (since TR > TC).
The break even chart is a flexible tool to quickly analyze the effect
of changing conditions on the firm. For example, an increase in the
price of the commodity can be shown by increasing the slope of the
TR curve. An increase in TFC of the firm can be depicted by an
increase in vertical intercept of the TC curve and an increase in
the AVC by an increase in the slope of the TC curve. The chart will
then show the change in the breakeven point of the firm and the
profit or losses at other output or sales levels.
Cost-volume profit analysis can be calculated algebraically. TR is 209
the price per unit times the quantity of output or sales (Q) Notes
TR = P. Q ___________________
TC = TFC + TVC ___________________
___________________
Since TVC = (AVC) (Q)
___________________
TC = TFC + (AVC) (Q)
___________________
Setting TR = TC and substituting QB (breakeven output) for Q we
___________________
have
___________________
(P) (QB) = TFC + ( AVC ) (QB)
___________________
Solving for break even output, we get ___________________
(P) (QB) - (AVC) (QB) = TFC ___________________
(QB) (P - AVC) = TFC
TFC
QB =
P − AVC
The equation can be modified to calculate the contribution margin

towards the fixed costs and desired amount of profit (λ).
TFC + λ
SB =
P − AVC
The profit volume (PV) ratio can also be used to find the BEP for
sales for multi-product firms. It can be calculated with the help of
a formula
⎡ S−V⎤
(100)
PV ratio = ⎢ −
⎣ S ⎥⎦
Where S is the selling price and V the variable cost. The PV ratio is
helpful in making choice of a product. If there is no time
constraint, then a product with a higher PV ratio should be
selected. On the other hand, PV ratio per time unit is taken as the
basis of choice in case of time constraint.
The linear approach to profit contribution has been criticized as it

considers both price and AVC constant. The price assumption is
not realistic for many firms, because they may not sell all they
produce at the going price.
Especially firms, where sales are large relative to the size of

market, may have to reduce price to sell more output. For some
firms, the assumption of constant AVC may be unrealistic. Also,
210
empirical studies suggest that the TC function is often close to
Notes linear, as long as the firm is not operating at or close to capacity.
___________________ However, if the price and AVC are roughly constant, at least over
___________________ the limited range of output relevant to the problem, breakeven
analysis is a useful tool for managerial decisions. But care and
___________________
judgment are required in its application.
___________________
Non-linear Break-even Analysis
___________________
If assumptions of constant price and AVC are relaxed we get non-
___________________ linear break even analysis (Figure 22.1b). There are two break
___________________ even points Q1 and Q3. Profit, the vertical distance between the
total revenue and total cost, is maximized at output rate Q2. The
___________________
output rate Q2 is relevant when the firm begins to earn profits. The
___________________ firm should not produce beyond Q2 because this would lead to
___________________ reduction in profit. No rational manager will expand production to
second breakeven rate Q3 and, therefore, it is irrelevant.
Contribution Margin
In short run, managers are concerned with the contribution
margin or contribution profit since fixed costs are sunk costs.
Break even charts can be used to measure the contribution of
business activity towards covering fixed costs. Average
contribution margin (ACM) is the difference between unit price
and AVC (P – AVC). Total contribution analysis can also be used to
determine the total contribution profit. Contribution is the
difference between the total revenue and variable costs. That is, it
is the revenue on the sale of unit of output after variable costs
have been covered.
Total contribution margin (TCM) = TR – TVC

or TCM = Total net profit (TNP) – TFC
Thus at the breakeven point
TCM = TFC and TNP = 0.
The equation also shows that
TR = TCM + TVC
= (TNP + TFC) +TVC
Uses of Break-even Analysis

Significant managerial decisions can be made from the break even
analysis.
1. Optimum level of output can be estimated from which the firm

will start earning profits.
2. It is used to determine the target capacity for the firm to get 211
the benefit of minimum unit cost of production. Plant Notes
Activity
expansion and contraction decisions are often based on break Give any one use of break-
___________________
even analysis. even analysis.
___________________
3. Profit or losses can be forecast from estimates of revenue and
___________________
cost.
___________________
4. Effect of change in volume of sales, price, and cost of
production can be analyzed. ___________________
___________________
5. Product mix can be determined - to produce or to purchase a
product and whether to drop a product line or not. ___________________
6. Effect of high fixed costs and low variable costs on the total ___________________
costs can be appraised. ___________________
7. Planning of cash requirements can be done from cash break ___________________

even.
The break even analysis is not free from limitations. In case of

multi-product or joint product firms the breakeven analysis can be
applied only if product wise estimates of cost and revenue are
available which is extremely difficult. It ignores the selling costs
and takes into account only the production costs. Despite these
limitations, the concept is used in production planning as it is
simple, inexpensive, and explains fundamental relationships
between revenue, costs, and profits.
Limitations
Break even analysis is generally used to find out the output level
at which the total fixed cost of a company are covered up by the
contributions. But due to non-availability of separate data for fixed
and variable cost for each product manufactured by the company
the analysis had to be carried out with respect to time.
The analysis itself has got some inherent limitations which have
been mentioned earlier.
The company considered manufacturing a wide range of products

and is operating at various locations. Hence, to carry out the
analysis at company scale is very complex procedure which
involves sorting of relevant data from a heap of data and then
compiling it in the form required by the analysis. Generally
companies don't differentiate very clearly and hence don't record
cost on the basis of fixed and variable cost.
212
Notes Data needed for the analysis is generally kept secret by the
companies – otherwise it can indicate their profit margins per unit.
___________________
___________________ 1. ................... is generally used to find out the output

level at which the total fixed cost of a company are
___________________
covered up by the contributions.
___________________
2. ................... is a straight line because AVC is taken as
___________________
constant.
___________________
___________________ Summary
___________________
In economics & business, specifically cost accounting, the break-
even point (BEP) is the point at which cost or expenses and
revenue are equal: there is no net loss or gain, and one has "broken
even". A profit or a loss has not been made, although opportunity
costs have been "paid", and capital has received the risk-adjusted,
expected return.
Lesson End Activity

With the help of internet, find out how non-linear break-even
analysis can be represented graphically.
Keywords
Break even charts: It can be used to measure the contribution of
business activity towards covering fixed costs.
Average contribution margin (ACM): It is the difference
between unit price and AVC (P – AVC).
Total contribution analysis: It can also be used to determine the
total contribution profit.
Contribution: It is the difference between the total revenue and
variable costs.

1. Explain the concept of break even analysis. How can
management use it as a tool for profit planning?
213
2. Explain the limitations of break-even analysis.
Notes
3. Describe the uses of break-even analysis.
___________________
4. Explain the linear and non-linear break-even analysis.
___________________
___________________
Further Readings
___________________
Book ___________________
Managerial Economic by Christopher R Thomas, S Charles ___________________

Maurice - Special Indian, 8th Ed, McGraw Hill Education. ___________________
Web Readings ___________________
___________________
www.wisegeek.com/what-is-profit-analysis.htm
___________________
en.wikipedia.org/wiki/Cost-Volume-Profit_Analysis
www.accountingformanagement.com/gross_profit_anal... - United
States
214
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
UNIT 23: Decision Making Process
Unit 12
215
Notes
Decision Making Process

___________________
___________________
___________________
Objectives
___________________
topics: ___________________
Quantitative decisions ___________________

Importance of variables ___________________
Importance of eight decision making tools
___________________
___________________
Introduction
___________________
A decision always involves choice among several alternatives. In
the most basic sense a decision always involves the answer to the
question "to do or not to do?" Not to do (inaction) determines that
decision. To do (action) usually involves different options. The
mathematical model identifies the optimal way, but for a variety of
reasons, other satisfying options may be selected and acted upon.
There are industry-wide and market-wide decisions that have to be
made. Often these decisions must transcend domestic
considerations to incorporate international aspects.
Managerial Decision Making System

Every decision making task results in an output which is the
evidence of the decision taken. In industry, it is ultimately some
kind of product, that is, a good service or on idea. The reasoning
takes place in the decision making rectangle which is sometimes
referred to as, quite appropriately, the black box. Here a
transformation of the inputs takes place that results in the output.
The transformation process has both physical and mental
properties. On the input side a large number of variables may be
listed. These variables can be classified in terms of the traditional
factors of production, i.e., land, labour and capital as well as the
more recently emerged complex variables related to systems,
technology and entrepreneurship. Underlying this input-output
system is a feedback loop identified as managerial control system.
Its function is to optimize the transformation of inputs into the
desired output. In a nutshell, in industry optimization means the
216 minimization of costs and the maximization of profits subject to

Notes
Activity legal, social and ideological constraints.
Define stochastic variables.
___________________
The computer has forced the decision maker to very carefully
___________________ delineate and quantify the variables that makeup the building
___________________ blocks of the decision task. What is needed and how much is
needed for decision optimization have become the important
___________________
questions. In addition, the proper time sequencing of the decision
___________________ variables within the decision process had to be understood. And all
___________________ answers had to be unequivocally quantified. It soon became
apparent to every decision maker that quantified variables had
___________________
different properties and specific quantitative control mechanisms
___________________ had to be designed. Not only was the decision maker confronted
___________________ with variable-inherent properties, the decision tasks themselves
have such peculiar quantitative properties.
___________________
A variable, the building block of the decision task, may be seen as a
small piece of a complex behaviour. Buying a house,
manufacturing a product, spending money on a show are examples
of variables. Each variable represents a distinct dimension of the
decision making task. So the decision space is always
multidimensional, and it is a major task for the decision maker to
find out which variables make up that space. If an important
variable is overlooked, obviously the decision will be less than
optimal. Furthermore, the quantitative impact of the variable
must be ascertained. And here the special variable-inherent
properties come into play. The following illustrations may show the
differences among the three types of variables.
Deterministic variables can be measured with certainty. Thus,

equal measures have equal cumulative impact, or, to use a simple
illustration, a + a = 2a.
Stochastic variables are characterized by uncertainty. Thus, a + a

= 2a + X, where X is a value that comes about because of the
uncertainty that is associated with the variable.
Heuristic variables are those that exist in highly complex,

unstructured, perhaps unknown decision making situations. The
impact of each variable may be explained contingent upon the
existence of a certain environment. For example,
a + a = 3a but only if certain conditions hold. Actual industrial
decision making situations in each case may involve the number of
gallons of aviation fuel obtained by cracking a barrel of crude oil
(deterministic), projected product sales given amount spent on
advertising the product (stochastic) and the construction of a
platform in outer space (heuristic).
217
Check Your Progress
Notes
Activity
Fill in the blanks:
Define managerial hierarchy.
___________________
1. Reasoning is ……………….. by nature, which can be
___________________
rational or irrational.
___________________
2. All types of human decision-making are essentially
___________________
……………… processes.
___________________
Managerial Decision Making Environment ___________________
The reason for the existence of a managerial hierarchy, that is, ___________________
lower, middle and top management, finds itself in different
___________________
parameters in which an organization operates. There are industry-
wide and market-wide decisions that have to be made. Often these ___________________
decisions must transcend domestic considerations to incorporate ___________________
international aspects. Such decisions—usually made by top
management—occur in a broad-based, complex, ill-defined and
non-repetitive problem situation. Middle management usually
addresses itself to company-wide problems. It sees to it that the
objectives and policies of the organization are properly
implemented and that operations are conducted in such a way that
optimization may occur.
You may note that while most of the quantitative decision making
tools—indeed virtually all of the deterministic tools—were
developed to optimize the decision making process, actual
managerial practice has sometimes moved away from that
objective. The previously mentioned legal or social constraints
often at times do not permit optimization and satisfying has been
substituted for it. Satisfying refers to the attainment of certain
minimum objectives. For example, a company may have the
economic and technological power to smother the competition
within its industry but refrains from doing so because of MRTP
considerations. Big size per se may be considered in violation of the
law or in the international arena, may result in the imposition of
quotas.
Lower management is responsible for the conduct of operations—

the firing line so to speak is this—in production, marketing,
finance or any of the staff functions like personnel or research.
This decision environment is usually well-defined and repetitive.
Obviously, with reference to a given decision making situation, the
distinction between top, middle and lower management may
become blurred. In other words, in any ongoing business there is
218
always a certain overlapping of the managerial decision making
Notes parameters.
___________________
The study and analysis of the existence and interaction of these
___________________ parameters is of great importance to the management systems
___________________ designer or communication expert. From the quantitative
managerial decision making point of view, their importance lies in
___________________
recognizing their peculiar constraints and then to build the
___________________ appropriate decision models and to select the best suited
___________________
quantitative decision tools. A brief discussion of each environment
in this light may enhance the understanding of the tools that are
___________________
discussed later on. The company’s approach to the domestic or
___________________ international market is filtered through industry-wide
considerations. What does the market want, what does the
___________________
competition already supply? Where is our field of attack? Do we
___________________ have the knowledge how do we have the resources? What is the
impact of our actions upon the market, our own industry and other
industries? These are some of the questions that have to be asked,
defined and answered. The problems are unstructured and
complex. Thus, often a heuristic decision making process can be
utilized to good advantage. Forecasting is of major importance and
hence stochastic decision making is widely employed in this
uncertain decision environment. But even a deterministic tool—
usually intended for decision making situations that assume
certainty—input-output analysis, can be effectively used in this
environment.
Middle management decisions are primarily company-wide in

nature. As mentioned before, these decisions steer the organization
through its life cycle.
Major features of a firm’s life are objectives, planning, operation

and the ultimate dissolution. The objectives are general and
specific in nature. Obviously, the top management establishes the
objectives, but middle management functions as their guardian.
Indeed, every decision at this level must provide feedback control
for each of the other components.
Planning refers to both policy execution as well as policy
development. Scale of production, pricing of the product, product
mix, in short the orderly and efficient arrangement of the input
factors is to be decided at this point. Making these factors into a
product is the job of operations. Some operations have been
traditionally called line (financing, production, and marketing) and
others staff (personnel, research, etc.); yet, in the quantitative
decision systems of the modern firm, such differences are difficult
to trace in the decision patterns, because the same decision, 219
making tools are employed. Since the decision environment at Notes
this level is somewhat more structured than at the top level but
___________________
still highly uncertain, stochastic decision tools are frequently
employed. In those finance, production and marketing situations ___________________
that can be well-defined, may be repetitive, deterministic ___________________
decision tools are found.
___________________
It may appear somewhat odd that the decision environment
includes attention being paid to the dissolution of the firm. The life ___________________
cycle concept has been mentioned, and it will be encountered again ___________________
as one of the major underlying conceptual aids in forecasting. It is
___________________
well known that business organizations are born, live and die
like natural organisms. ___________________
Therefore, decision making should always be cognizant of ___________________

the possibility of dissolution. That moment comes when, to
___________________
use the vernacular, good money is thrown after bad. While
market forces and the application of quantitative analysis
normally show the approaching occurrence of that moment—
even if the management involved shuts its eyes to the facts or is
ignorant about them—at this point the decision is made or
superimposed to opt for a turnaround or dissolution. Public
agencies unfortunately are rarely subject to such stress producing
alternatives.
The lower management decision making environment represents a
specialized, narrowly defined area within a company’s total
decision or operational field. Supervisory personnel of all types are
operating in this environment. The decision tasks are
normally well defined and repetitive. While the element of
uncertainty never leaves the decision environment, here
uncertainty can often be programmed into general or sub-
routine and stochastic decisions taken as if they were
deterministic in nature. A good example is the pricing system of
clothing discounters. Merchandise is put on the floor at price A
on day one. On, say, day ten the price is automatically
reduced to price B and so on until the article is either sold
or given to charity after thirty days. This is known as
programmed decision making. It should be noted that while the
nature of the decision environment remains intact, the decision
maker’s tasks have been greatly reduced. The complex variables
and unstructured decision environment of the merchandising task
have been placed first into a model and then into decision
making sequence (algorithm). This is the general idea
behind model building and the development of algorithms.
It is highly important that every decision maker has a firm
understanding of the philosophy upon which quantitative
decision making is based. Under no circumstances is it
sufficient to just
220
know how to perform a certain quantitative analysis and to obtain
Notes a solution to be able to make a decision.
___________________ To turn to the specific aspects of the quantitative decision making
___________________ process, it is possible to recognize three distinct phases in every
decision situation. Given a carefully defined problem, a conceptual
___________________
model is generated first. This is followed by the selection of the
___________________ appropriate quantitative model that may lead to a solution. Lastly,
a specific algorithm is selected. Algorithms are the orderly
___________________
delineated sequences of mathematical operations that lead to a
___________________ solution given the quantitative model that is to be used. The
algorithms generate the decision which is subsequently
___________________
implemented by managerial action programs.
___________________
Problem Definition
___________________
___________________ Problem definition is a cultural artifact which is especially visible

in a society’s economic and industrial decision making process.
Obviously, if such cultural determinants are operative in the first

phase of managerial decision making, their effect can be noticed at
various stages in the process irrespective of the quantitative, thus
hopefully objective, methods that are used in the design of the
models and algorithms as well as the decision itself.
A brief digression into problem identification may be in order at

this point. For purposes of this book and for quantitative
management decision methodology in general, it is presupposed
that a problem has been identified.
In the private sectors of free enterprise economies, however, a

manager’s ability to recognize problems and even to anticipate
problems that may emerge at some future time is vital to the
survival of the firm. Those managers that make effective decision
concerning a known problem are good administrators; those that in
addition can recognize and anticipate problems are creative. It is
known that creativity is partially inborn and partially acquired.
Thus, the quantitative decision maker will not only try to master
the methodology but also attempt to sharpen his or her problem
identification skills—his or her creativity.
The Design of Conceptual Models

The conceptual model represents the logic that underlies a
decision. Based on this logic the quantitative model and specific
algorithms are constructed. The logic may be a priori or empirical
in nature, e.g., when shooting craps in a casino, a gambler has pre-
established a conceptual model concerning the odds of the game.
On a priori ground—using only his or her intellect—in determining 221
the odds of every roll of the dice, the concept dictates that the win Notes
Activity
of a seven or eleven on the first roll has likelihoods of 6/36 and 2/36 ,
What does the conceptual
___________________
respectively. (There are 6 possible combinations of spots showing model represent?
on 2 dice that yield a seven and 2 combinations that yield an ___________________
eleven with 36 combinations for all spots from two through twelve.) ___________________
Given this conceptual model, quantitative models and algorithms
___________________
can be designed that facilitate the betting decision.
___________________
Now suppose that our gambler stumbles across a floating craps
game in some dark alley. After observing the action on the ___________________
pavement for a while, he notices that seven’s and eleven’s do not ___________________
occur on the first roll with the likelihood dictated by his conceptual
___________________
model. Rather there seems to be a preponderance of two’s, three’s
or twelve’s—which he knows are losses. Crooked dice, he may very ___________________
quietly think to himself. For crooked dice, an a priori logic which is ___________________
based on the ideal situation in which every spot on a dice has an
equal probability of occurring (1/6) and any spot on two dice as well
(1/6 × 1/6 = 1/36) according to the multiplication theorem) is
unsuitable. Rather, he will now ascertain by observation (by
experiment) the empirical probabilities which are determined by
the weights that have been cleverly or crudely (it is a dark alley)
concealed in or on the dice. Once this empirical conceptual model
has been generated, our gambler may continue the betting decision
process in terms of the amount of the bets at each roll, etc. He may
also redefine the problem and leave.
Conceptual models may take many forms. In every case the

general design intent is to understand and to depict the reality
that relates to the problem. Most conceptual models show a
functional relationship in graphic or matrix format. All models
that are used in this book are of this type. But it is also
possible, indeed necessary in some decision cases, to build a
physical model. In the natural and engineering sciences, it is the
usual form. If the decision involves mass production of some item,
the physical model is known as a prototype.
In the design of the conceptual model, it is important to observe

that the decision maker clearly delineates the interrelationships
that make up the reality—or the systems—in which the problem
occurs. But in the model building process it is virtually impossible
to include all variables that have a bearing on the decision. The
model includes only the major variables (endogenous variables) as
seen from the decision maker’s vantage point. There will be always
decision-related variables that exist outside of the decision space
222
(exogenous variables) because of their unrecognized status or
Notes
conscious exclusion due to time, cost or limited impact
___________________ considerations. Such variables should be kept mentally ready
___________________ because over a set decision horizon they may indeed become
sufficiently important to be included into the system.
___________________
___________________
Once the conceptual model has been designed and its logic
expressed in terms of some systems configuration such as the
___________________
graph or matrix or perhaps network or flow diagram, the
___________________ quantitative models are simply superimposed by quantifying the
___________________ logic. Once that has been accomplished a relatively minor task
remains in the selection of the algorithms and the computerization
___________________
of the process. Many decision processes have been needlessly and
___________________ most of time injuriously to some extent, commenced because of
___________________ faulty problem definition or poor conceptual model building. Then
there is no optimal or even satisfying outcome. To put it simply,
number crunching and possible error correction is relatively easy,
even though the reader may not immediately share this view as he
or she does just that in the chapters that follow. Only the difficult
tasks, that is, sound insight into the problem and its careful
definition as well as proper logic employed in the conceptual model
building process, will yield sound decisions and outcomes. Here
errors are very difficult to correct.
Quantitative Models
Once the conceptual model has been properly designed, the
quantitative model and its algorithms should almost “flow” out of
it. The transition is natural, smooth, and almost automatic. The
quantitative model is selected from the many such models that
have been designed by mathematicians. So while the decision
maker will always build a conceptual model, the quantitative
model is typically selected from an available pool of such decision
making tools. The selection is made on the basis of the
predominantly stochastic, deterministic or heuristic nature of the
variables. There are available quantitative models for each kind as
discussed in the following chapters, and the decision makers task
is to select the appropriate one for a given decision situation.
“Know thy tools” should be inscribed on every decision maker’s
desk. As it is possible to build a wall with a spade when the trowel
would be the more appropriate tool, decision makers may
sometimes misuse quantitative tools.
The Decision 223
A decision always involves choice among several alternatives. In Notes
the most basic sense a decision always involves the answer to the
___________________
question “to do or not to do?” Not to do (inaction) determines that
decision. To do (action) usually involves different options. The ___________________
mathematical model identifies the optimal way, but for a variety of ___________________
reasons, other satisfying options may be selected and acted upon.
These other options are firmly rooted in an organization’s ___________________
objectives and planning activities. As shown in greater detail later, ___________________
a decision maker always has control over setting the objective and
planning which interfaces with policies, strategies and tactics. But ___________________
one has no control over the reaction to the decision within ___________________
the market environment. Here various states, collectively
___________________
known as the states of nature, emanating from customers,
suppliers, competitors, public agencies, etc., render the final ___________________
judgment about the soundness of the decision. The decision is the
___________________
end product of a sequence of mental activities as illustrated in the
preceding pages. To make a decision does not necessarily mean
that it gets carried out. In order to accomplish that, numerous
managerial action programs are necessary. They represent the
physical extension to the decision making process. This book stops
at the point when the decision is rendered. The action programs,
the physical component, cannot be discussed because they must be
specifically designed for each situation. A good decision maker,
however, will try to place the seeds for proper implementation
into the decision.
Check Your Progress
Fill in the blanks:
1. Inertia is often due to a fear of…………… .
2. Problem definition is a cultural artifact which is
especially visible in a society's economic and
industrial……………… .
Summary
Every decision making task results in an output which is the
evidence of the decision taken. A variable, the building block of the
decision task, may be seen as a small piece of a complex behaviour.
Buying a house, manufacturing a product, spending money on a
show are examples of variables.
The reason for the existence of a managerial hierarchy, that is,

lower, middle and top management, finds itself in different
parameters in which an organization operates. There are industry-
wide and market-wide decisions that have to be made.
224
The conceptual model represents the logic that underlies a
Notes decision. Based on this logic the quantitative model and specific
___________________ algorithms are constructed. Once the conceptual model has been
properly designed, the quantitative model and its algorithms
___________________
should almost "flow" out of it. The transition is natural, smooth,
___________________ and almost automatic.
___________________
The mathematical model identifies the optimal way, but for a
___________________ variety of reasons, other satisfying options may be selected and
___________________
acted upon. These other options are firmly rooted in an
organization's objectives and planning activities.
___________________
___________________ Lesson End Activity

___________________ Find out more about the quantitative models of decision making
processes.
___________________
Keywords
Deterministic variables: Deterministic variables can be
measured with certainty.
Stochastic variables: Stochastic variables are characterized by
uncertainty.
Heuristic variables: Heuristic variables are those that exist in
highly complex, unstructured, perhaps unknown decision making
situations.

1. Every decision making task results in an output which is the
evidence of the decision taken.
2. Define variable. What are the different types of variables?
3. What are the key decisions taken at different managerial
levels?
4. Write a note on problem definition.
5. Discuss the process of designing conceptual and quantitative
models.
Further Readings
Books
R S Bhardwaj, Mathematics for Economics and Business, Excel
Books, New Delhi, 2005
D C Sanchethi and V K Kapoor, Business Mathematics 225
Notes
Sivayya and Sathya Rao, An Introduction to Business Mathematics
___________________
Web Readings
___________________
www.managementstudyguide.com
___________________
www.textbooksonline.tn.nic.in ___________________
www.mathbusiness.com ___________________
___________________
___________________
___________________
___________________
___________________
226
Notes
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________

Economics & Management Decisions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Economics & Management Decisions

Uploaded by

Copyright:

Available Formats

UNIVERSITY OF TOMORROW

SLM Development Team

Dr. Arvind Jain

Dr. Kabir Sharma

Dr. Shantanu Trivedi

PhD, M.Com., NET

Course Code : ECON7034D

@All Right Reserved with CCE UPES

Unit 1 Introduction to Managerial Economics ......................................................................... 3

Unit 11 Break-Even Analysis ................................................................................................................ 207

\ Concepts of economic analysis ___________________

Nature of Managerial Economics

Baumol believes that economic theory is helpful to managers for

Managerial Economics is micro-economic in nature because it deals

Contribution of Quantitative Techniques to Managerial

Thus, Managerial Economics deals with the economic principles

Managerial Economics plays an equally important role in the

Check Your Progress

___________________ A firm applies principles of economics to answer these questions.

Table 1.1: Basic Questions & Related Concepts ___________________

Basic Questions Related Concepts ___________________

Appropriate business decision making with the help of economic ___________________

Check Your Progress

1. ................... theory guides the manager in the selection of

Role of Managerial Economist

1. What product and services should be produced?

2. What inputs and production techniques should be used?

___________________ 5. When should the equipment be replaced?

___________________ 6. How should the available capital be allocated?

Check Your Progress

1. A ........................... makes an assessment of change.

Economics and Managerial Decision Making

Example 1: Reliance Industries has maintained top position in

RPL is planning to expand its capacity from 27 to 30 million tonnes

Example 4: In late 1990s, HLL earned supernormal profits

To ward off rivals and to make it a better competitor the company

Example 5: Apple, the company that began the PC revolution, had

Check Your Progress

Firm: It is an organization that combines and organizes resources

Long Run: It refers to a time period sufficient enough to vary all

Macroeconomics: It is the study of economy as a whole. It deals

Microeconomics: It is concerned with the study of individuals like

Opportunity Cost: This is the amount of subjective value foregone

Scarcity: It can be defined as a condition in which resources are

Questions for Discussion

1. Define managerial economics with definition.

2. How does managerial economics differ from economics?

3. Write a short note on managerial economist.

___________________ 5. Explain the role and responsibilities of managerial economist.

___________________ Managerial Economics by Karampal and Surender Kumar, 1st

A Brief Analysis of Utility

\ Meaning of utility ___________________

14 phenomenon as one derives satisfaction from a commodity only

u (2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, ___________________

Check Your Progress ___________________

Fill in the blanks: ___________________

1. ...................is a representation of preferences over some ___________________

set of goods and services. ___________________

2. Contrary to the consumer’s point of view, utility is

If a consumer consumes n number of commodities, his total utility,

Check Your Progress

___________________ Where TU = total utility, and DQ = change in quantity consumed

___________________ Another way of expressing marginal utility (MU), when the