UNIT - 1 FUNDAMENTALS OF

MANAGERIAL ECONOMICS
STRUCTURE
1.0 Learning Objectives
1.1 Introduction to Managerial Economics

1.1.1 Managers
1.1.2 Economics

1.2 Meaning of Managerial Economics

1.3 Features of Managerial Economics
1.4 Nature of Managerial Economics

1.5 Scope of Managerial Economics

1.5.1 Operational or internal issues
1.5.2 Environmental or external issues
1.6 Importance of Managerial Economics
1.7 Firm Objectives
1.8 Role of managerial economist

1.9 Business Economics

1.9.1 Introduction
1.9.2 Business economics vs managerial economics

1.10 Consumer Theory

1.10.1 Law of Demand
1.10.2 Substitution effect
1.10.3 Income effect
1.10.4 Demand Curve
1.10.5 Concept of Utility
1.10.6 Consumer Equilibrium
1.11 Summary
1.12 Self-Assessment Questions

1.13 Suggested Readings

1.0 LEARNING OBJECTIVES

 To help students use economic tools to explain the optimal
allocation of resources within the firm.
 To assist students know the concept of pricing and demand.
  To assist students know regression analysis, estimation and
forecasting, and game theory and apply them in managerial
decision-making.

1.1 INTRODUCTION
Let’s suppose that after finishing your studies, you have got a job as an
automobile engineer in a car manufacturing company. Here, you will plan
to manufacture a huge amount of automobiles of an essential quality at the
lowest price possible. On the flip side, if you are at the designation of a
sales manager, you will have to manage the minimum ad price with
maximum sales. Selling the products at a maximum cost, increasing the
returns, and minimizing the advertisement costs are the main principles of
managerial economics. There are many issues that managers have to face
daily. These issues include the product’s pricing, the amount of the goods
to be supplied, whether the product gets produced internally, can the
product be bought from outside, and profit from the quantity under
production, among other issues. Managerial economics teaches the basics
for solving the problems regarding managerial designations. Managerial
economics (ME) is a side-shoot of two well-defined disciplines, i.e.,
economics and management. A proper understanding of these two
disciplines is required to understand its complete nature and scope.
It was brought into existence as a field in the U.S in 1951, after the book
named “Managerial Economics” was published by Joel Dean. This book
referred to the process of making
A manager has responsibility for their action, but then the tasks of other
employees, machines, and other things, which are the duties of a manager.
These responsibilities can be related to multinational corporations or even
a single household. In both cases, a manager has the responsibility of
getting the task accomplished by the resources by directing them.
decisions for a company. The book also can be deemed as the economics
of management. Managerial economics is also called business economics
or industrial economics. As the publisher noticed, the book illustrated how
economic analysis could be used to formulate new policies of a company.

1.1.1 The manager

A manager is one who gives directions to various resources to reach a
specific goal. All the individuals in the firm performing the below actions
can be referred to as the managers:
● Directing others to perform tasks, including the ones assigned by
other people in the organization.

● Buying the raw material or input for the services to get developed
in the firm.

● Taking others’ decisions, such as deciding the price for a product

or the quality.
1.1.2 Economics
Economics is the branch of social science that involves decision making
in a scarcity of resources. Resources can be anything, for example, raw
materials used to produce goods and services or achieve a specific goal.
Decision-making is vital in such scenarios as scarcity means giving up
something by deciding to achieve something else. Therefore, economic
decisions are related to resource allocation when there are scarce
resources. The manager allocates the resources to the team so that they can
work to achieve the assigned goals. As an example, a food bank will spend
more on buying soups than buying fruits. Similarly, a computer firm will
be spending more on advertising instead of investing in the development
and research.
Economics, which is the best decision-maker for an organization, helps
make the top decisions for resource allocations, in case of the shortage of
the resources.
While understanding managerial economics, you will come to know that
the time is the scarcest resource. So every decision involves the resource’s
allocation for achieving the goal within time.

1.2 MEANING AND DEFINITION OF

MANAGERIAL ECONOMICS
Managerial economics can be defined as a field that uses economics theory
and business administration practice methodologies. It completes the
missing concepts between real business activities and basic economics
theory. It provides various tools and techniques, allowing the managers to
make all decisions in practical and real-life situations. It also works as a
combining course to reveal the relation between many areas where a
company functions.
Definition of Managerial Economics
Managerial Economics is an important element of economics focussing on
Micro level. The subject has a direct impact on business environment and
it deals with problems that are faced by the business firms. Managerial
economics provides a set of tools and techniques to the form for solving
critical problems rather than suggesting a readymade solution. Managerial
Economics is related to certain important terms of economics and analysis
tools that are applied in the systematic process of effective decision
making.
Decision making is difficult process involving the selection of a particular
alternative among different alternatives. The responsibility is on the
decision maker who should have great knowledge and understanding to
take profitable decisions for the business.
Managerial economics is related to application of economic aspects and
tools to analyse business situations and perform effective decision making.
According to Mc Nair and Meriam, “Business economic consists of the
use of economic modes of thought to analyse business situations.”
Spencer and Siegelman defined Managerial Economics as “integration of
economic theory with business practice for the purpose of facilitating
decision- making and forward planning by management.”
DC Hague defined as “Managerial Economics uses the logic of
Economics, Mathematics and Statistics to provide effective way of
thinking about business decisions problems.
1.3 FEATURES OF MANAGERIAL ECONOMICS
Read the following features to understand the managerial economics:
i. Close to macroeconomics: It is all about solving the various
managerial issues of a company. Hence, it is close to
macroeconomics.

ii. Normative statements: A normative statement consists of words

such as ‘should’ or ‘ought’. They are gestures of what a group
ought to do. For example, it handles statements like ‘The State
Government should take some strict action on crimes’. These
statements express views on what is correct or incorrect, and what
is good or bad, and on the basis of value judgments. These
statements mainly deal with the upcoming time, and disagreements
on these statements are finalized by voting.

iii. Works against the macroeconomics background: The

economy’s macroeconomics conditions can be seen limiting parts
for an organization to run. So, a managerial economist should
know the limits that macroeconomics conditions have set.
Examples of these limits can be inflation, industrial policy that the
government imposed.

iv. Prescriptive actions: Prescriptive actions lead to the goal. When

the problem statements and the objectives to achieve for a firm are
known, prescriptive action helps deciding various options that can
lead to an optimal solution.

v. Applied in nature: Models are created to provide the solutions to

real-life business problems as these models help managers to make
decisions. The model building gets utilized for project
management, optimization, and inventory control. In addition to
model building, case study methods are used to understand the
problem, find the different solutions, and finalise the best solution.

vi. Evaluate each alternate: Managerial economics assists in

evaluating all the alternatives concerning revenue and overall
costs. The managerial economist can take the best decision in
finding a cost-effective option that can increase the firm’s profit.
vii. Interdisciplinary: Managerial economics (ME) is related to
various subjects. These include statistics, mathematics,
management, accountancy, sociology, economics, and more.

viii. Limitations and Assumptions: Each theory and concept used in

managerial economics is made based on some assumptions, whose
validity is, of course, not universal. It is because when some
assumptions change, the theory becomes inapplicable.

1.4 NATURE OF MANAGERIAL ECONOMICS

This field is the youngest among all the social sciences. As it has come out
of economics, it shares basic features with economics. The basic
assumptions made in managerial economics (ME) are similar to that in
economics. These assumptions are made such that the managerial
phenomenon can get simplified to understand, while many factors are
continuously changing.
These problems include the various assumptions that do not hold true in
reality. As an example, consider that a buyer is rational. But this is not true
as the buyers’ behaviour and preferences vary with the incentives and
advertisements. But making assumptions, it offers an easy way to know
the complex phenomenon that managerial economics follows. Hence,
making assumptions is the only alternative.

1.5 SCOPE OF MANAGERIAL ECONOMICS

Scope of any field decides its area of study, so is the case with Managerial
Economics (ME). It assists management get the strategic planning tools
that help understand the working style of the firms. It also helps businesses
gain maximum profits. Managerial economics mainly operates according
to the theories in economics and principles that help managers make the
below five types of decisions about resources:
● The decision about the service or the product to produce.

● Selection of the method to be employed for production.

● Decide the best minimum rate that can get good profit.

● Strategies and activities to promote the products in services.

● The location’s choice, where the manufacturing will occur, and the
products will be ready for sale.

The production department, the finance department, and the marketing &
sales department take these five different decisions. Out of these five
decisions, managerial economics mainly deals with two areas.
1. Operational/internal issues

2. Environmental/external issues
1.5.1 Operational or internal issues
These issues are internal to the business organisation and are taken care of
by the management. Below are the operational issues:
i. Demand forecasting and theory of demand

ii. Pricing strategy

iii. Analysis of Production cost

iv. Resource allocation

v. Profit analysis

vi. Capital and investment analysis

vii. Strategic planning

i. Demand analyses & forecasting: An organisation can survive only

when it can fulfil the demand of its products sufficiently and within the
proper time. Therefore, it is necessary to understand the various concepts
of demand, which helps in demand forecasting. As most of the activities
that occur at any firm depend upon the demand predictions, and demand
analysis makes crucial activity for any firm. Demand analysis assists in:
● Analysing the market influence on the products and the firms, and
adapt according to these influences.

● Evaluating factors that impact the demand for a product. It also

helps in manipulating demand. So, demand analysis influences not
only the price but cross-elasticity and income too. There is a spike
in the function that Managerial Economics offers of demand
analysis.

ii. Pricing & competitive strategy: Pricing decisions have always been
within managerial economics. And, pricing policies are a little subcategory
of the problems of managerial economics. Also, price theory helps to
reveal how rates get decided in various conditions of the market.
Advertising & marketing strategies are parts of the competitions analysis.
iii. Resource allocation: The main goal of firms is profit-making. But it
involves many constraints such as competition with similar products in the
market, changing business environment, and input price. Therefore, some
risks are always involved, despite proper planning. Apart from future
profit planning, the profit theory helps to manage and calculate the profit
and return.
iv. Capital or investment analyses: Capital is the base of a successful
business as the shortage of capital may lead to small operations. A
sufficient amount of the capital from different sources such as institutional
finance, equity capital, and others can assist in big-size operations. So, the
managers should pay attention to the management and allocation of capital
on priority. Check out some issues related to the capital analysis below:
 ● The selection of investment project assessment of the
sufficiency of capital.

● Well-planned allocation of capital.

The capital theory assists the most while making decisions on investments.
It includes analysis of the capital cost, capital budgeting, and more.
v. Strategic planning: Strategic planning gives management a structure
on which some decisions, which affect the firm’s behaviour, are made. The
firm sets some objectives and also chooses the strategies accordingly to
reach there. Strategic planning is the latest member of managerial
economics’ scope with an increase of multinational companies.
It opposes the project planning that concentrates on a specific activity or
project. It’s a combination of strategic planning and corporate economics,
which is another area of study.

1.5.2 Environmental or external issues

Environmental issues refer to the social, economic, and political
environment where a firm functions. The economic environment study
should have:
i. Kind of economic system followed in the country,

ii. Analysing the trends in employment, production, prices, income,

investment, and saving

iii. The working trends of different financial institutions such as

Financial and Insurance companies, banks, and more,

iv. Working trends within foreign trade,

v. The working trends of capital markets and labour,

vi. Different economic policies implemented by the government.

Environmental issues have a social environment referring to social

organizations and the social structure that includes trade unions and
consumer cooperatives. The political environment means state activity
types, mainly the state attitude towards political stability and private
business.
Environmental issues mainly feature the firm’s social objectives, i.e., how
a firm is responsible for society. Firm objectives are not only about their
private gains.
Environmental issues relate managerial economics and macroeconomic
theory. Conversely, operational issues relate managerial economics to
microeconomic theory.

1.6 IMPORTANCE OF MANAGERIAL

ECONOMICS
The digital world involves increased business decisions. Hence,
Managerial Economics (ME) is increasingly becoming important. And it
is supportive of several business decisions.
Helpful in business organisation: How and for whom should a product be
produced? The managerial economy is the answer to all these types of
questions as it plays a crucial role in this. Its role is so crucial in making
decisions for the business. It’s role and importance both are helpful to
choose some crucial decisions that an organization needs to take.

i. Helpful in planning business

Business economics helps plan reasonable prospects among the
production and operation of any firm. It acts as a stabiliser between
operating systems and production tools. So, it upholds an
outstanding role for any firm in business economics.
ii. Helpful in cost control
Managerial economics concludes whether the business is in profit
or loss. It also decides how a firm can grow. For this, managerial
economics has a big role in the decisions of cost control.
iii. Helpful in coordinating various business activities
It is quite helpful in organizing numerous business activities.
iv. Supportive in demand for casting
Managerial economics is quite helpful in providing various
functional tools for economics managers. It also helps in
demanding production planning. It also handles upcoming losses
with ease. So, a firm can get guarded against coming losses.
v. Useful in profit planning and control
Managerial Economics assists the managers in decision-making on
the planning of the benefits. It keeps in sync both planning and
control for any firm. Its importance is increasing as it plays a
crucial role in business decisions.
vi. Cooperative in predicting the business
No one knows how the business is running. Wherefore, business
economics lets us know what issues a firm will be facing in the
future. Managerial economics (ME) is always there for solutions.
So, a firm can be protected, and the benefits can get maximized.
vii. Useful to find the product price
To predict the business pricing, managerial economics gives the
required guidance and provides the required data to maximize
benefits. It is an important role of the field, in a business decision,
as the business cannot grow without this.
viii. Useful in solving the taxation issues
Managerial economics gives proper solutions to business taxation
problems—the contracting of business helps minimize the
problems and maximize the profits at a suitable cost.
ix. Supportive in knowing the process of economic system
Business economics is helpful to understand the complications
because of the whole economy. The entire economy is
complicated, but business economics resolves it with ease. That is
how business economics is so helpful in business decisions.
x. Useful in analyzing the effects of government policies
Managerial economics helps to analyses the effect of different
government policies in making a business sector. It minimizes the
negative influence and gives benefits to the good ones. The value
of managerial economics is upstanding. Changing the policies
regularly has some unpleasant effects on several businesses. But
managerial economics utilises it with ease and benefits the
business.
xi. Try to put out an affectionate business
Managerial economics assists managers to adapt according to the
external business conditions. These external conditions include
business cycles, various government policies, several other
circumstances that impact the business. So it provides security to
an organization.
xii. Helpful in manufacturing and use of models
Managerial economics builds a model for managers to motivate the
use in business. Business economics helps in managing things, so
everything goes in the right way to increase profits. Business
economics plays a crucial role in performing all this in business
decisions. That is how important managerial economics can be for
business.
xiii. Supporting in economy welfare
Managerial economics motivates managers to run the business, so
the firm gains the highest economic welfare.
xiv. Helpful in showing the right way
Managerial economics has a vital role inside the business because
it connects to that business. It provides the right way for each
member of an organization and shows the right way.
xv. Cost maintenance
Managerial economics performs its duties by assessing what
amount should have use in business and how to manage the
expenses, minimize costs, and maximize profits.

xvi. Give out the profit

Managerial economics lets us know about distributing the profits.
Also, investing the money to get good results for future growth in
the business field.
xvii. Evaluation of productivity
Managerial economics uses a huge number of helpful tools, which
assist managers in evaluating the productivity of an organization.
Managerial economics has a vital role in it, so managerial
economics (ME) can assist the business in making the right
decisions in several ways.

1.7 FIRM OBJECTIVES

Below are the main objectives of a firm:
i. Profit maximization: Maximizing profits is the major objective
of a business organization. To meet this objective, the cost and the
expected product, which is under competition are determined.
Mainly, the demand and cost are the two conditions that hold
importance. Profit maximization satisfies the shareholders. So,
they could have an opportunity to reinvestment and make their firm
more efficient. Profit maximization occurs when marginal cost and
marginal revenue become equal.
 Source: upload.wikimedia.org
Fig 1.1: Profit Maximization
ii. Sales maximization: An economist Baumol, the primary objective
of any company is to maximize sales. According to him, when a
company prioritizes sale maximization as one of the primary
objectives. Profit maximization itself becomes another objective.
Sales maximization occurs when a company produces the goods in
as much as quantity, sufficient to enhance the business size.

Source: www.economicsdiscussion.net
Fig 1.2: Sales Maximization
iii. Utility maximization: It is an end target of any company.
Economist Benjamin Higgins believes that smaller companies
should have the utility maximization objective. Utility
maximization is called preference function maximization. The way
to achieve the utility maximization in a business is by expanding
the employees and increasing their salaries. Also, it is performed
by setting up discretionary funds to enhance the company’s
project.
 Source: upload.wikimedia.org
Fig 1.3: Utility Maximization
iv. Revenue maximization: According to the Sales Revenue
Maximization model by Baumol, revenue maximization is the
main objective of any firm. The model states that a firm should
work to maximize sales revenue.

Source: www.economicsonline.co.uk
Fig 1.4: Revenue Maximization
v. Output maximization: Milton Kafolgis puts an output
maximization as the main objective of the firm over revenue and
profit maximization. According to Kafolgis, a firm’s performance
directly depends on its physical output, having revenue in the
second spot. Also, he emphasised that any firm will spend the
funds to increase production rather than spending on
advertisements.

1.8 ROLE OF MANAGERIAL ECONOMISTS

All the managers in every firm have to perform in mainly two kinds of
tasks—information processing and decision-making. In the past few years,
with a hike in companies’ sales and productions, the managerial
economist’s role and importance have also increased. Consequently,
people having a deep knowledge of the analytical tools and theories are
designated as managerial economists.
A managerial economist has a responsibility to make policies for an
organization. They analyse both external and internal operations in the
organization and apply their skills to make profitable decisions for an
organization. They make decisions belonging to the sales, labour, pricing,
profitability, and financial issues by considering various goals of an
organization.
Talking about the internal management of a firm, managerial economists
make decisions about inventory schedules, sales, and production, taking
place in the firm. Overall, the decision-making of managerial economists
revolves around quality improvement, expansion of output, fixation of
price, plant location, etc.
Another significant role managerial economists play, belongs to the
demand forecast. Demand forecasting holds importance in an
organization, because the general business conditions uphold an important
role in the success of an organization. Managerial economists prepare the
short-term forecast plans regarding the usual business activity and relate
that to the trading trends. Every firm requires two kinds of forecast plans—
the short term as well as a long term. The short-term plans last for three
months, and long-term plans are for a year and more. However, they must
consider the changing preferences of the customers. Hence, market
evaluation is necessary regularly for understanding the ever-changing
customer tastes. Thus, a managerial economist has to be skillful in doing
market research. This research is mandatory to forecast, because it
provides the firm all the necessary details of an existing position, with
possible future trends. An expert managerial economist assists an
organization make new product policies, strategies to promote the
products and sales, and plans for the improved products.
The managerial economists also perform the economic analysis for a
company. It belongs to the evaluation and feasibility of projects taking
place in the organization. For instance, a managerial economist should
have the ability to make judgments, keeping the cost-benefit analysis in
mind for a company, and decide if the project will be successful for an
organisation or not and whether the organisation should continue with the
project or not. Economic analysis can be referred to the general business
environment, knowledge about competition, and foreign and internal
sales.
Security management analysis is one more function that a managerial
economist performs. This task is crucial for the industries, which are
security-oriented, such as nuclear plants and power projects. The role and
importance of security management is to keep the secrets of the trading
and production about technology and other quality-related information
that should not get leaked. This role holds more importance in the projects,
which need strategies, are defense-oriented, and are of national
importance. A managerial economist needs to manage all these security-
related issues for these organizations.
Performing an advisory function is one of the roles of the managerial
economists. Being a part of this role, the economists need to make
decisions of various matters in trade and production. For any organisation,
managerial economists hold a position higher than the top executive in the
management team. The managerial economists have responsibility to
advise about all the trades’ matters to the organization’s top executives as
managerial economists know the technical and financial aspects about the
actual functioning of trade within the organisation.
Managerial economists have to deal with many problems regarding the
pricing for a company. It’s a right pricing strategy that marks the success
of any company. Also, pricing decisions being the most challenging
decision for a business as the businesses are lacking the required
information fully. Undoubtedly, the costs of the established products are
distinct from the prices of new products. Managerial economist makes the
pricing related decisions. They need to be dynamic in their pricing
decisions to be in sync with the changing environment. For this, they need
to speculate the competitors’ reactions and manage in an environment
restricted by government rules.
Finally, the managerial economists have to perform the function to analyze
environmental problems. Managerial economics assists in identifying the
social responsibility of any organisation. It means what impact a company
leaves on the environmental factors. To exemplify, the impact should be
positive on the environment. If possible, the firms should try contributing
to preserve and protect the environment.
The managerial economists are responsible not only for decision-making,
they also involve analyzing and giving recommendations to policy
making.
So, managerial economists should be well-versed in analyzing and
operating by understanding the facts well. For smooth functioning, they
need internal quantitative data from a company, and external environment
data, such as trends, market conditions, and trade cycles. Using all this
information, the managerial economists coordinate the policies related to
investment, production, price, and inventory.
A managerial economist has to be cool and calm to meet the crisis. He has
to proceed in a controlled manner after discussing with the concerned
departments. He also should have statesmanship while giving advice to the
top designated executives of the company and should get cooperation from
the other departments. Moreover, they have to be intuitive to anticipate if
something is good or not for any organization. Additionally, managerial
economists should have a thorough theoretical understanding of handling
day-to-day challenges.

1.9 BUSINESS ECONOMICS

1.9.1 Introduction
Business economics or managerial economics is an application of the
methodologies and theories of economics in business. Business economics
involves making a decision for choosing one out of two or more action
courses. This question arises because primary resources like labour, land,
management, and capital get bounded and be utilized in other operations.
Each business requires the attention of its top executives. As these
executives have to choose a top decision among many, available to them.
It would favour the business that helps to achieve the target of a company.
A systematic formulation of the problems of the business, and figuring out
the best solutions to these problems need an organization to be well-
equipped with proper tools and a rational methodology. Business
economics fulfils the firm’s requirements in business.

1.9.2 Business economics versus managerial

economics
Business Economics (BE) is a sector of applied economics, which deals
with quantitative methods and economic theory to analyze business firms.
The factors, which come up with the diversity of the managerial structures
and the firm’s relations with labour, product markets, and capital, are
examined.
Conversely, managerial economics is a division of economics that handles
economic concepts. It also handles the analysis of issues, required to
articulate managerial decisions. That is a subsection of economics that
utilizes microeconomic analysis for management units and making the
decisions.
Differences between the business economic and managerial economics are
below:
Business Economics
i. Business Economics (BE) is a division of applied economics that
utilizes various parameters of quantitative methods and economic
theory for analyzing the business organisation. It is dependent on
microeconomics in two different levels, i.e., normative and
positive nature.

ii. Business economics is related to a broader area as it handles

economic problems related to the business industry.

Managerial economics
i. It is explained as economics used for making decisions.

ii. Managerial economics assists in examining and making decisions

at the managerial and micro level.

iii. Managerial economics holds a normative nature.

1.10 CONSUMER THEORY

Consumer theory is an area of economic theory. It explains how
consumers behave concerning the changes in cost and income, and how
consumers’ purchasing habits change with prices? Consumers are free to
choose between different bundles of goods and services. With the
understanding of consumer theory, demand analysis can get predicted.
Advantages of consumer theory concerning demand analysis:
It is important to know consumer purchasing behaviour and income as it
directly affects the demand curve. The demand curve is a relation between
the cost of products and the quantity demand for a period. If the purchase
of a product decreases, there is a fall in demand for products and services.
It will affect the company’s profits and the labour market. Hence, it has a
direct relation between the demand and the revenue earned.

1.10.1 Law of demand

According to the law of demand, the demand for any commodity rises
when the price of a commodity reduces, and when the price increases, the
demand declines, considering other factors remain constant. The law of
demand represents the inverse relationship between the product’s price
and demand among customers. It implies that if the price of the product
spikes, then its demand lessens. Conversely, if the product’s price goes
down, then there is a spike in the product’s demand.
According to Professor Paul Samuelson, the law of demand is stated as “if
a good gets into the market in a huge quantity, then the consumers will
purchase it at a lesser price, but with the condition that other items remain
constant. The law is on the basis of the noted facts and can be easily
verified using empirical data. Therefore, this law is empirical. This law
remains true when the conditions remain constant. These conditions are
the consumer’s income, good’s price, consumer’s preferences and taste,
etc. However, the mentioned conditions or factors are constant only for a
short while. Therefore, the law holds for a shorter time.

Source: https://www.investopedia.com
Figure 1.5: Law of Demand
Assumptions in the law of demand:
The law of demand rely upon the below assumptions:
i. The income of the consumer is the same.

ii. The consumer’s preferences do not change.

iii. The rate of the substitutes of the good is constant.

iv. The prices of the commodities are not expected to change in the
upcoming future.

Demand schedule
Demand schedule is the list of prices sorted in ascending or descending
order with their corresponding quantities that consumers can purchase per
unit time. The demand schedule can present the law of demand. The
demand schedule generally has two columns. One column has prices in
either ascending or descending order, and another column contains the
quantity desired. Based on research, the price could be decided.
Price Quantity of Chocolates
50 10
40 8
30 6
20 4
15 3
10 2
5 1
Table 1.1: Demand Schedule
For every price of chocolate, a fixed amount of chocolate is in demand.
Here, in this table, as the price goes down, the chocolates demand goes up.
The law of demand is on the basis of this relation between demand and
price.
Factors affecting the law of demand
As we discussed, the demand curve has a downward slope that presents
the law of demand, i.e., the demand for commodities decreases as the price
hikes and vice versa. Below are the main two factors that impact the law
of demand:
1. Substitution effect

2. Income effect

1.10.2 Substitution effect

As per the substitution effect, when the commodity’s price goes down,
while the price of other substitutes of the commodity remains constant,
then the substitute goods get relatively costly. In simple words, when the
cost of any commodity reduces, the commodity becomes cheaper than its
substitute.
Since the commodity has become lower-priced than its substitute
commodity, more consumers will buy it, and consequently, its demand
will increase. This spike in demand, on the basis of this factor, is known
as the substitution effect.

1.10.3 Income effect

When the cost of any commodity reduces, the consumer’s real income
lessens for the same amount of the commodity. Due to a hike in the
consumer’s real income, the consumers demand more of the mentioned
commodity. The rise of demand due to a spike in the consumer’s real
income is an income effect.
Also, it should be noted that a value of an income effect gets negative for
inferior products.
If a cost of inferior products decreases for a specific amount of a
commodity, the consumer’s real income will increase, making them richer.
As a result, the consumer gets enough money to purchase the substitutes
of commodities, i.e., the superior goods, and demand for poor products
gets lesser. Therefore, the income effect becomes negative for the inferior
quality goods.
Utility maximizing behaviour
Under the law of diminishing marginal utility conditions, the utility-
maximizing behaviour makes a demand for commodities raised at a
decreased price. As everyone knows, the consumer exchanges money with
the commodity, while purchasing the commodity that consequently
satisfies the customer. The consumer keeps on buying the commodity until
the marginal utility of his/ her income gets lesser than the marginal utility
of the commodity being purchased.
Consider the price of the commodity is known, consumer adjusts his
buying habit, such that:
MUm = Po = MUo.
Equation 1.1
As the price decreases, MUm = Po < MUo as a result, the equilibrium gets
disturbed. Getting the equilibrium again, a consumer needs to reduce
MUo to become equal to MUm.
A consumer can do so, by purchasing the commodity in more quantity till
MUm value, gets equal to MUo. It’s the main reason behind why demand
hikes with the fall in the commodity cost.

Source: upload.wikimedia.org
Figure 1.6: Utility Maximizing Behavior
The exception to the law of demand
This law does not hold in the below cases:
i. Expectations about further price: When the cost of some durable
commodity is expected to spike in the upcoming time, the
customers will purchase that commodity in high quantity, instead
of the increased price. The consumers will purchase to be away
from paying more money to purchase that commodity in the
upcoming future. As at the time of recession, the rate of wheat
tends to rise. Still, consumers will purchase wheat more than the
required quantity for storage.

ii. Status goods: The law of demand doesn’t hold for the
commodities, which are used as a status symbol to show wealth
and richness. Gold, old paintings, precious stones, and antique
items are an example of such status goods. The wealthy people
purchase these items, even when their prices hike.
 iii. Giffen goods: A Giffen good refers to an inferior commodity,
which is comparatively low-priced than its substitutes. Poor people
use these Giffen goods as a basic necessity. If the cost of Giffen
goods rises, the demand also increases, while assuming the cost of
their substitutes remains the same.

It is because the income effect for Giffen goods is greater than the
substitution effects. It is understood by taking an example. When
the cost of the inferior commodity rises and the income is the same
as before, the poor people will reduce using the superior
substitutes. So, they can afford the inferior commodity that is the
primary necessity of poor people.

1.10.4 Demand curve

It represents the price schedule in graphical form and presents the law of
demand. It also refers to some points, which shows a different combination
of quantity and cost. We can plot the data of a table, used above for getting
the demand curve. It is the graph plotted between the columns of the
demand schedule, i.e., quantity and the cost of the commodity in demand
per unit time. Every point on the demand curve represents a combination
of quantity and cost in demand. This price quantity combination moves
downward as both have an inverse relationship with each other as already
discussed. If we read this curve downwards, then it implies as the price
reduces, the quantity in demand increases. Similarly, if we read the curve
upwards, it means, with an increase in the price, its demand declines. So,
the demand curve represents a relation for a particular time, such as a
week, day, month, year, or season.
Why do demand curves slope downwards?
As everyone knows, as per the law of demand, there is an indirect relation
between the product’s price and the product’s demand in the market. But
the question arises, why is an inverse relation there. Below are the reasons
behind this inverse relation or the downfall of it:
i. Applicability of law of diminishing marginal utility: As the
marginal utility curve (MUC) moves downwards, therefore, the
demand curve moves downward as well.

ii. Substitution effect: When the cost of any goods decreases lesser
than the substitutes of the products, then the demand for the
products increases.

iii. Income effect: Because of the positive income effect, the real
income increase, and demand also rises when the cost of the
products decreases.

iv. When the prices go down, the product becomes affordable to more
people, and more consumers get attracted.
 v. As the cost falls, the consumer starts using the products for not so
essential purposes that expands the demand.

However, in some situations, the law of demand acts differently. In this

kind of scenario, the consumers buy the goods at an unreasonable price,
rather than a reasonable price. It makes the curve of demand slope
upwards. Examples of this kind of exceptional cases are war situations,
and when the commodity is the key necessity to live, like wheat.
Derivation of the demand curve
As we saw, it is a curve plotted between quantity in demand and the cost
of the commodity per unit time. We have also read that the demand curve
goes downward, we can prove that using the indifference curve analysis.
Let’s take an example of commodities—burgers and hot dogs. Let’s
assume the hot dog’s price remains constant, while there is a fluctuation
in the cost of burgers. The consumer is having a budget of Rs. 200 to buy
these commodities. Consider the burger’s cost is Rs. 5; then a consumer
can buy 40 burgers only, but the consumer’s utility is maximum at point
A in an I1 curve that represents 20 burgers. If the burger’s cost reduces to
Rs. 2, then a consumer can afford a maximum of 100 burgers. But the
Equilibrium will get attained at point B with 56 burgers. If the price of
burgers reduces more to INR 1, then the consumer can purchase 200
burgers. But, equilibrium will get attained at point C, which represents 107
burgers. As it can be seen with an example—as the burger’s price
decreases, the quantity in demand increases, as per the law of demand.
This example was for the individual, but in managerial economics, we are
usually interested in plotting the demand curve for a company or the
market. It is achieved by adding all the quantities in demand by different
consumers. For example, two consumers A and B, want to purchase
burgers, when the cost of a burger was Rs 5, consumer A likes to purchase
25 burgers, and consumer B demands 35 burgers. So, the burger's demand
in the market will become 60 burgers for Rs. 5 each. This is the way we
can get the demand curve for several customers.
Shift in the demand curve
When there is a fluctuation in the position of the demand curve (shape may
/ may not change), it is known as the shift in the demand curve. For
example, there are a total of three demand curves, i1, i2, and i3. Consider
i2 as the original demand curve of commodity X for price OP2. Now, the
consumer buys commodity X in quantity OQ2, while other factors remain
the same. In such cases, other factors, like the consumer's income and the
cost of substitute goods, change. There might be a change in the
consumer’s ability to purchase commodity X. It will be a reason for a
change in the demand curve i2, and the demand curve will change its
location and that is known as a shift in a demand curve.
The reason behind the shift in the demand curve
The shift in the demand curve occurs because of the change in one or more
than one factors impacting the demand of the commodity. For example,
the demand for commodity X decreases from Q1 to Q2. If the cost of a
commodity is OP2, there is a fall in demand because of the following
reasons:
i. There might be a reduction in the consumer’s income, such that he
can purchase commodity X in OQ1 quantity at price OP2. It is
called an income effect.
 ii. There is a reduction in the price of substitutes of X. So, a consumer
feels like buying a substitute commodity and it is called a
substitution effect.

iii. There might be a change in the preference of the customer because

of the advertisement of the substitute products. So, the consumers
will purchase a substitute product instead of X. It’s also a
substitution effect.

iv. The cost of commodity X has increased in the way, the consumer
can afford to buy only the OQ1 quantity of commodity X.

v. The cost of commodity X is constant. But demand decreases due

to reasons, such as commodity X is out of trend, lower in quality,
product seasonality, and a change in the taste of the consumer.

Source: https://www.thebalance.com
Fig 1.7: Shift in Demand Curve

1.11.5 Concept of utility

The theory of consumer behaviour is dependent on the concept of utility.
As per the concept of utility, the utility is measurable. The utility can be
multiplied, subtracted, or added. As per the cardinal approach, we can
measure the utility using the cardinal number such as 1, 2, 3, 4, and many
more. The term ‘Util’ was coined by Fisher for measuring the utility. As
per the cardinal approach, a consumer gets 5 Utils from a coffee cup, and
15 Utils out of a piece of cake.
Meaning of utility
The utility is defined as the quality present in the commodity in economics
that satisfies the consumer’s needs. In simple words, this is the satisfying
ability of the commodity. Different economists have given different
definitions for utility as per Mrs Robinson “Utility is what the feature of
the commodity that forces the customers to urge the want to purchase”. As
per Hibdon, ‘Utility is the quality of a product for satisfying a want’.
Features of utility:
 i. The utility is subjective: it’s because the utility works to make a
person mentally satisfied. However, the same commodity can have
distinct utility values for different consumers. For example,
alcohol has some utility for an alcoholic person, but one, who never
drinks, does not have the utility of alcohol. Hence, the utility is
subjective.

ii. The utility is relative: The commodities utility varies as per the
time and location. Example, a room heater has utility during
winters but no utility during summer season.

iii. Utility and usefulness: Commodity having some utility should

have some usefulness. For example, sweets are a utility for those
who love eating sweets, but sweets are very harmful for health as
they cause obesity.

iv. Utility and morality: Utility has no relation with morality. As an

example, using opium is unethical morally, but opium-eaters find
utility in it for satisfying their intoxicants.

Concept of utility types

Following are the different concepts of utility:
i. Initial utility: Initial utility (IU) is the utility, which gets obtained
after consuming the very first unit of the product and commodity.
Example, the utility, which gets derived after consuming the first
bread piece, is the initial utility. The initial utility has positive
value.

ii. Total utility: The total of utility obtained by consuming the

multiple units of any commodity in a household is (TU) total
utility. As per Leftwich ‘total utility is total satisfaction amount,
which gets derived after consuming the commodity’. For example,
a man has three chocolates, and he gets ten utils after eating the
first chocolate, six utils from the second, and five from the last one.
So, TU of chocolate for him will be 21 utils. The TU has the below
formula:

TU = MU1 + MU2 + … + MUn

Equation 1.2
Here, TU is the total utility.
MU1, MU2, … MUn is the marginal utility of 1st, 2nd, 3rd, … Nth
unit.
 iii. Marginal utility: The utility derived after adding more quantity of
any commodity is marginal utility (MU). Simply, the changed
value of total utility after consuming extra commodity unit is
marginal utility. Chapman has given the definition of marginal
utility as “Addition to TU value after consuming an additional unit
of the commodity” For example, someone gets ten utils from 1st
chocolate and seven utils from 2nd chocolate, the marginal utility
is 10 – 7 = 3 utils. The value of marginal utility (MU) can be
positive, negative, or zero. The formula for marginal utility (MU)
is as below:

MU (n) = TU (n) – TU (n-1)

Equation 1.3
Here, Mu (n): marginal utility of the nth unit.
TU (n): total utility derived from n units.
TU (n-1): total utility obtained after consuming the (n-1) unit.

1.10.6 Laws of utility analysis

Utility analysis has two laws
● Law of diminishing marginal utility

● Law of equi-marginal utility

Law of diminishing marginal utility

The law of diminishing marginal utility says when the amount of any
commodity consumed increases, the commodity utility diminishes with
time. In simple terms, as the customer takes any product, he gets
satisfaction from its utility. But this satisfaction diminishes, as consumers
take more of this product. We can understand this by taking a simple
example from our daily life. Consider that someone eats chocolate daily,
but after some time, he may get bored and chooses another chocolate or
similar item to purchase and consume. It is because his satisfaction
diminishes with time as he was getting initially.
Law explained
A commodity X1 is consumed, and its utility gets measured quantitatively.
Below is a table showing the marginal and total utility of X1:
UNITS OF X1 TOTAL UTILITY MARGINAL UTILITY

1 30 30

2 50 30

3 60 20

4 65 10

5 60 5

6 45 -5
Table 1.2 Marginal Utility Table
As seen in the table, as several units for a commodity gets increased with
time, the item’s total utility increases but, at a slower rate, while the MU
decreases continuously. If we draw the total with marginal utility (MU)of
these commodity units, then the graph will be as below:
Clearly, the curve where as the units utilized for a goods hikes, and the
marginal utility (MU) reduces. At unit quantity 4, total utility value
becomes maximum and then starts sloping down. From this point onwards,
with the increased quantity of used units, marginal utility becomes
negative.
Assumptions for the law of diminishing marginal utility
i. Rationality: As per the law, a customer thinks logically who wants
to maximize the utility for any item as per his earnings and the
commodity cost.

ii. Utility measurement: The utility of any commodity is measurable

in quantifiable terms, like a rice bag, a pair of jeans, a cup milk,
etc.

iii. Marginal utility constant for money: Marginal utility (MU) of

the consumer’s money is assumed as fixed.

iv. Homogeneity of commodity: The product quantities consumed

are considered the same as in size, shape, quality, colour, etc.

v. Continuity: The consumed units of utility of commodity get

assumed to be continuous at regular intervals.

vi. Ceteris paribus: Different factors consisting of consumer income,

consumer taste, and price of the products are assumed as
unchanged.

Exceptions to the law of diminishing marginal utility:

i. The law of diminishing marginal utility shows exception or does
not hold good in the case of the below scenarios:

ii. The law is not true for rare collections, such as old coins, precious
items, or when a drunken person consumes alcohol.

iii. Law is not wholly true for money as the richness increases, there
is decrement in the money marginal utility.

Importance of law of diminishing marginal utility

i. Base for the law of demand:

Law of diminishing marginal utility is the fundamental law used in

economics that makes the base for law of demand.
 ii. Basis of progressive tax-policy:

A progressive tax-policy can be formulated using law of

diminishing marginal utility.
iii. The basis for redistribution of wealth policy:

The policy of Public Expenditure that the government creates, also

dependent upon the law of diminishing marginal utility.
iv. The optimal consumption level:

Law is utilized to determine the optimal consumption level. It gets

achieved, where the law of diminishing marginal utility parallels
its cost.
v. Forms basis to produce things:

This law helped to create and manufacture different things.

Law of equi-marginal utility
Law of equi-marginal utility describes the relation between using two
and more commodities and in what combination, the two more
commodities will give optimal satisfaction. Marginal commodity means
the additional satisfaction, which is gained when one more commodity
gets consumed.
Assumptions for law of utility
i. The consumer is logical and wants maximum satisfaction.

ii. The usage of each commodity is quantifiable.

iii. The marginal use of money is constant.

iv. The incomes of the consumer are known.

v. The commodity prices are known.

vi. This makes the base of the law of diminishing marginal utility.

Law of diminishing marginal utility explained

Consider a consumer who has a fixed income and has to purchase the two
products A1 and B1. The consumer being rational, will spend income on
buying the two products to maximize the overall utility and maximize the
satisfaction. As the consumer achieves that, the equilibrium state gets
reached.
The law written symbolically as below:
MUa/Pa = MUb/Pb = MUm
Equation 1.4
Here, MUa represents the marginal utility of commodity A1
MUb represents the marginal utility of commodity B1
Pa is the cost of commodity A1
Pb is the cost of commodity B1
MUm refers to the marginal utility.
MUa/Pa and MUb/Pb refers to the marginal utility of expenditure.

Limitations of the law of equi-marginal utility

 i. Indivisibility of products: This law becomes inapplicable when
goods are indivisible. Such goods or commodities are cars, houses,
etc., which are indivisible.

ii. Marginal utility constant: Marginal utility remains constant for

money, which gets inapplicable in most cases.

iii. Not possible to measure utility: The customer is ready to

purchase a commodity that has a price the same as the marginal
utility value of the good. But as per modern economists, if two
consumers pay equal for any good, it does not imply that that the
utilities of both commodities is similar. The utility is unmeasurable
in quantitative terms.

iv. Interdependency of utilities: The commodities and their marginal

utilities are independent. But actually, the commodities are not
independent because commodities are either complements or
substitutes. Hence the utilities are also interdependent.

v. Indefinite budget period: Indefinite budget period is another

limitation of this law. The budget period is generally considered as
the financial year. But, for some commodities, this period follows
one after the other accounting periods.

1.10.7 Consumer equilibrium

A consumer gets the Equilibrium state when he obtains maximum
satisfaction once the product gets consumed and is not ready to change his
purchases.
Assumptions
i. It is assumed that the consumer has a fixed income and can spend
all the income money by purchasing two goods P and Q.

ii. P and Q have a fixed price for a consumer.

iii. Goods are homogeneous and divisible.

iv. Consumer can think logically and want the maximum satisfaction
from the usage.

v. An indifference map is defined that shows the preference scale a

consumer has for multiple combinations of P and Q goods.
Source: https://lh3.googleusercontent.com
Figure 1.8: Consumer Equilibrium and Indifference Curve
To understand indifference curves, consumer Equilibrium, let’s first
understand the below terms:
Budget line: It shows the multiple combinations of products, which a
customer can purchase with a fixed money when the costs of the products
are fixed. Below is the equation to denote budget line:
M = PxX + PyY
Equation 1.5
Here, M is the budget of a consumer.
Px is the price of X,
Py is the price of Y.
Indifference map: It shows the preference scale of a consumer for
different blends of the products.
If a person spends all his money buying a burger, he can purchase an M/Pb
quantity of burgers. Similarly, a person can buy an M/Ph amount of
hotdogs by spending all his money. Consider the consumer likes to buy
both the food items, considering the cost of the items and his income are
fixed. For getting the maximum satisfaction level, he will buy both the
items in quantity, such that he buys the maximum of both of the items by
spending all his money. Below is an indifference map that shows the
indifference curves for burgers and hotdogs:

Source: www.railassociation.ir
Figure 1.9: Indifference Curve
To get fully satisfied, the consumer wishes to get the highest indifference
curve possible for a given budget. I1, I2, and I3 are three indifference
curves. Any combination of these two products on these curves gives the
same utility. To achieve consumer equilibrium, which is when the
customer gets fully satisfied, it is needed to combine the different
indifference curves with a budget line. In our case, the consumer can take
the two products X and Y within budget M with quantity at A and B in I1.
They can also achieve the equilibrium by consuming the products X and
Y in quantity combining with C in indifference curve I2. C describes the
equilibrium point here
.

1.11 SUMMARY
Managerial economics is the sub-field of economics that uses the theories
and methods of economics for decision-making. Business is a broader term
that includes every transaction type that occurs in-between two parties.
Decision-making process in ME consists of various steps, including
perceiving the problem, objective defining, understanding the constraints,
identifying strategies, evaluating strategies, and finalizing the criteria to
fetch the best strategy. Managerial economics (ME) has relation with other
subjects/fields of decision science, theories of economics, and business
function. Applied economics has branch business economics that uses the
economics theories and methodologies to get the product markets and
business enterprises. Business economics has many similarities with
managerial economics (ME) with few differences.
Managerial economics has grown a lot in recent times, so is its demand in
business. Managerial economists play a very significant role in the firms
that include decision-making, predicting price, and offering various
alternatives to top executives that help them in making decisions for the
firm’s welfare. The different theories that are applied in managerial
economics are demand theory, the theory of the cost and production
theory, competition theory, and price theory. The field assumes that
individual agents are rational. The demand term is used in various contexts
as part of demand schedules, demand curves, demand quantity. The
different contexts between these terms should be understood. The law of
demand shows the indirect relationship between cost and quantity of goods
demanded. The indirect relationship between the cost and quantity in
demand can be determined using the indifference curve. Income effect and
substitution effect are two factors that affect the Law of Demand. Different
concepts of utility are initial utility, marginal utility, total utility. The two
laws of utility are the law of equi-marginal utility and the law of
diminishing marginal utility.

1.12 SELF-ASSESSMENT QUESTIONS

A. Descriptive Type Questions
1. Define managerial economics.
2. Explain the decision-making process.
3. Describe the law of diminishing marginal utility in detail.
4. Define the law of demand.
5. Define marginal utility.

B. Practical/Scenario Based Question

1. Demand curve first slopes down and then moves up. Discuss.

2. A Market allocates those resources to the firms, which meets the

customer needs best. Discuss.

3. Advertising and profitability works parallely and have direct

dependency. Discuss this statement.
 4. I have a very small shop but I can sell a product at a lesser price
than that at a shopping mall. The person selling in the shopping
mall needs to pay rent, but I do not need to pay rent. Discuss.

5. A company distributes profit during the financial year and still

expects it to be worth at year end. Discuss it. Also, discuss profit
for decision-making.

C. Multiple Choice Questions

1. _______ is the type of utility that one gets after consuming the first
unit of a good.

a. Total utility

b. Initial utility

c. Utility

d. Marginal utility

2. The indirect relationship of commodity demand and price is stated

by which law?

a. Law of diminishing marginal utility

b. Law of equi-marginal utility

c. Law of demand

d. Law of utility analysis

3. Which of the below is not a firm’s objective?

a. Welfare maximization

b. Profit maximization

c. Sales maximization

d. Output maximization

4. Which of the given options is not an operational issue in the scope

of managerial economics?

a. Profit analysis

b. Strategic planning
 c. Capital or investment analysis

d. Working trends of capital market

5. Which out of below is not an assumption in the law of demand?

a) Customer taste remains unchanged.

b) The commodity price does not change.

c) The salary and other income sources of the consumer

remains constant.

d) Units of the goods are homogenous.

6. Managerial economics forms by the combination of business

………. and economics theory?

a) Management

b) Practice

c) Ethics

d) All above options

7. Which of the below costs gets recorded in books of accounts?

a) Explicit cost

b) Average cost

c) Marginal cost

d) Total cost

8. Supply of product can be enhanced by …………., considering

other conditions remains unchanged.

a) increasing the seller’s income

b) rising customer’s income

c) improving the production techniques

d) rising the goods price

9. How can we get the curve of demand for consumers?

a) Income consumption curve

b) Engel’s curve
 c) Price consumption curve

d) None

10. Competitive equilibrium causes

a) Production in excess capacity

b) Production at cost more than minimum

c) Production at least cost

d) Few firms producing at increased rate while others at

decreasing

Answers:
1 - B, 2 - c, 3 - a, 4 - d, 5 - d, 6 - b, 7 - a, 8 - c, 9 - c, 10 – b

1.13 SUGGESTED READINGS

Reference books
● Gopalakrishna, D. (2017). A Study of Managerial Economics.
New Delhi: Himalaya Publishing House.

● Hague, D.C. (1969). Managerial Economics. New Jersey:

Prentice Hall Press.

● Dean, J. (1951). Managerial Economics. New Jersey: Prentice

Hall.

Textbook references
● Perloff, Jeffrey M. and Brander J.A. (2018). Managerial
Economics and Strategy. New York: Pearson Education
Limited.

● Ahuja, H. N. (2007). Managerial Economics. New Delhi: S.

Chand Publishing.

● Seth, M. (2009). Micro Economics. Agra: Lakshmi Narain

Agarwal Educational Publishers

Websites
 https://www.managementstudyguide.com/consumer-demand.htm
 https://www.investopedia.com/terms/l/lawofdiminishingutility.as
p
 https://www.economicsdiscussion.net/consumers-
equilibrium/consumers-equilibrium-with-diagram/25160