Managerial Economics

What is Economics ?
Economics is the science of choice in the face of
unlimited ends and scarce resources that have
alternative uses.

Since resources are scarce and the uses to

which they can be put to are unlimited, one is
required to choose the best amongst the
available alternatives.
Several thinkers have given different
definitions of economics.

According to Alfred Marshall, economics is

the study of mans actions in the ordinary
business of life, it enquires as to how he
gets his income and how he utilises it.

Thus on the one hand it is the study of

wealth, on the other it is the study of man.
• According to Lionel Robbins, economics
studies human behaviour as a relationship
between unlimited ends and scarce
means, which have alternative uses.

• Thus, Robbins says that, economics can

help a man to choose how to make use of
his scarce means for the maximum
satisfaction of his unlimited ends.
It was J.M.Keynes who pointed out that
economics also dealt with issues
concerning the nation as a whole.

Keynes defined economics as the study

of administration of scarce resources
and of the determinants of
employment, income and growth.
What is managerial economics?
Managerial Economics is concerned with
the application of economic principles
and methodologies to business decision
problems.
 Foundation of Managerial
Economics
• Economics can be broadly divided into two
categories:

• microeconomics
• and macroeconomics.

• Macroeconomics studies the economic system

in aggregate and relates to issues such as
determination of national income, savings,
investment, employment at aggregate levels, tax
collection, government expenditure, foreign
trade, money supply, price level, etc.
• micro-economics studies the behavior of an
individual decision-making economic unit like a
firm, a consumer, or an individual supplier of
some factor of production

• In simple terms, managerial economics is

applied micro-economics. It is an application of
that part of micro-economics, which is directly
related to decision making by a manager.
• Thus, “managerial economics analyses
the process through which a manager
uses economic theories to address the
complex problems of business world, and
then take ‘rational’ decisions in such a
way that the preconceived objectives of
the concerned firm may be attained”

(Barla, 2000).
• Like an economy, the manager of a firm also
faces five basic issues:-

• 1) Choice of product, i.e., the products a firm

has to produce - A manager has to allocate the
available resources, so as to maximize the
profit of the firm.

• (2) Choice of inputs – After determining the

profit maximising level of output, the manager
has to identify the input-mix which would
produce the profit maximizing level of output at
minimum cost.
• (3) Distribution of the firms’ revenue –
• The revenue received by the firm through sales
has to be distributed in a just and fair manner by
the manager.

• Workers, owner of factory building, bankers, and

all those who have contributed their materials and
services in the process of production, storage and
transportation, have to be paid remunerations,
according to the terms and conditions already
agreed upon.
• The residual after such payments constitutes the
firm’s profit which has to be distributed among the
owners of the firm after tax payment.
• (4) Rationing - This constitutes an important
function of a manager.

• He/she should utilize the scarce resources

optimally, which involves expenditure.

• As the manager has to often look after several

plants simultaneously, he/she must prioritize
not only the allocation of resources but also the
time.
• (5) Maintenance and expansion – In addition,
the manager has to plan strategies to ensure
that the level of output is maintained, the
efficiency of the firm is retained over time, and
also to plan the future expansion of the firm.

• Expansion of the firm imvolves making

adequate provisions for mobilizing additional
capital from the market and/or borrowing money
from banks.

A dynamic manager always aspires to expand the

firm’s scale of operation, so as to increase the
profits.
 Circular Flow of Economic Activities
• Economic analysis attempts to explain the working of
economic systems.
• Assume a simple economic system consisting of two
sectors, whose activities are systematically connected
with one another. The economic activities performed
by economic agents are generally classified into three
inter-related activities:

• a) Supplying factor inputs, like land, labour, capital,

organisation and enterprise, which enable the agents
to earn incomes which in turn could be used for
purchasing consumable goods;
• (b) Using the factor inputs (raw materials,
machines, labour, land, etc.) for producing
goods to be supplied to the consumers; and

• (c) Providing intangible and specialized

services directly to the people (example,
lawyers, teachers, doctors, and porters) or
working for the government (example, soldiers,
judges, policemen, etc.).
• The nature and dimensions of economic
activities are generally determined by the extent
of overall economic development. For instance,
a developed economic system like that of the
United States or Japan, has more specialized
activities and division of labour, as compared to
a traditional economic system
• Forms of Organisation
• In modern times, organisation of business assume
several forms, viz., sole proprietorship, individual
entrepreneur or one-man business, partnership, joint–
stock companies, industrial combination, co-operative
enterprises and State enterprises.

• a) Individual Entrepreneur: Under the ‘one-man’

concern, organiser invests his/her own capital and
may also borrow some.
• He/she rents a shop and employs a worker, if
necessary. He/she personally make purchases and
attends to the sales, and is also the owner manager,
who also takes the entire risks.
• Thus, an entrepreneur organizes, directs all economic
activity and takes the full risks, and is the sole
proprietor.
• b)Partnership: In partnership firm, two,
three or more people join together,
contribute capital, and share the profits
and risks of losses in agreed proportions.

• c) Joint-stock company: It is the most

important type of business organisation
today. It overcomes the disadvantages of
the artnership arising out of small
financial resources and limited business
talent.
• Co-operative enterprise:
• They are of two types –
• 1) producer’s cooperation, and
• 2) consumer’s cooperation.

• i) Producers cooperation: Under it, the workers take

up the entrepreneurial work, They contribute some
capital and borrow the rest; elect their own foreman
and managers and employ other staff. After all
expenses on rent, capital, salaries and wages, the
profits are divided by the workers.
• This type of co-operation is called the productive co-
operation or producer’s co-operation.
• ii) Consumer’s cooperation: Under it, the
consumers of a region contribute small
shares of capital and start a store. These
co-operative stores buy goods from
wholesalers or, and sells them to the
members at the market price.

• The profits are shared by the members in

proportion to their purchases or,
commonly, in proportion to their capital
share. Usually, the capital share is
contributed equally and therefore profits
are, also equally shared by the members.
• State enterprise: The organisation of state
enterprise is similar to that of the private
enterprises with consisting of general manager,
foremen, works manager, accountants,
treasurer, departmental heads, etc.

• Its working is generally similar to that of a joint-

stock company. But, the fundamental difference
is that all its employees are government
servants with fixed tenure and pension benefits
on retirement. The capital comes from the state
revenue, which are attributed by the tax-payers.
Therefore, the profits, if any, go to the state.
• Public enterprises: Public enterprises may be
in the form of
• i) Departments, i.e., run by a government
department, e.g., railways and posts and
telegraph in India,

• ii) Corporation, e.g., Life Insurance Corporation

of India established by a special Act of
Parliament, and

• iii) Limited Liability Company registered under

the Companies Act.
Definition of Managerial Economics

Managerial Economics is the discipline

that deals with the application of
economic concepts, theories and
methodologies to the practical
problems of businesses /firms in
order to formulate rational managerial
decisions for solving those problems
Basic economic problem :-

-Resources are scarce

-Uses to resources are unlimited
-Hence, decisions are required at every
stage of production

Be it,

Sourcing of inputs, conversion of inputs into

outputs or distribution of output.
Finding optimal solutions to all such managerial
problems is rendered easy by the concepts
and theories of economics and the
methodologies of the decision sciences.

The basic concepts of demand, cost, production

and price, along with the theories of consumer
behavior, profit maximisation and market
structures help in finding out optimal
solutions.
The subject that uses the theories of
economics and the methodologies of
the decision sciences for managerial
decision-making is known as
managerial economics
 Nature of managerial economics
The nature of managerial economics is
defined by factors such as :

1. Is essentially microeconomic in nature

2. Is pragmatic
3. Belongs to normative economics i.e
besides being descriptive, it is also
prescriptive
• is conceptual in nature
• Utilises some theories of macro
economics
• Is problem solving in nature.
• Microeconomics is the branch of
economics that deals with the individual
units of an economy.

• Since managerial economics is concerned

with the analysis of and finding optimal
solutions to decision-making problems of
businesses/firms, it is essentially
microeconomic in nature.
• Managerial economics is a practical subject.

• It goes beyond providing rigid and abstract

theoretical framework for managers.

• Economics can also be classified as positive

and normative. Positive economics describes
what is, i.e observed economic phenomenon.

• Normative economics on the other hand

prescribes what ought to be i.e it distinguishes
the ideal from the actual. Managerial economics
is prescriptive, not merely descriptive
• Managerial economics is based on a sound
framework of economic concepts.

• Its subject matter is not an arbitrary collection of

prescriptions. It aims to analyse business
problems on the basis of established concepts.
Thus it is also conceptual in nature.
Besides analysing the managerial problems
of business units, managerial economics
aims at finding out the optimal solutions to
the business problems of firms.

In other words, it is problem solving in

nature.
 Scope
Managerial economics helps in the following

Estimation of product demand

Analysis of product demand
Planning of production schedule
Deciding the input combination
Estimation of cost of the product
Achieving economies of scale
Determination of price of product
Analysis of market structures
Profit estimation and planning
Planning and control of capital expenditure
• 1. Definition.

• Managerial economics is the science of directing

scarce resources to manage cost effectively.
• 2. Application. Managerial economics applies to:
• (a) Businesses (such as decisions in relation to
customers including pricing and advertising;
suppliers; competitors or the internal workings of
the organization), nonprofit organizations, and
households.

• (b) The “old economy” and “new economy” in

essentially the same way except for two distinctive
aspects of the “new economy”: the importance of
network effects and scale and scope economies.
i. network effects in demand – the benefit provided
by a service depends on the total number of
other users, e.g., when only one person had
email, she had no one to communicate with, but
with 100 mm users on line, the demand for
Internet services mushroomed.

ii. scale and scope economies – scaleability is the

degree to which scale and scope of a business
can be increased without a corresponding
increase in costs, e.g., the information in Yahoo
is eminently scaleable (the same information can
serve 100 as well as 100 mm users) and to
serve a larger number of users, Yahoo needs
only increase the capacity of its computers and
links.
Iii Note: the term open technology (of the
Internet) refers to the relatively free
admission of developers of content and
applications.
• (c) Both global and local markets.
• 3. Scope.
• (a) Microeconomics – the study of individual
economic behavior where resources are costly,
e.g., how consumers respond to changes in
prices and income, how businesses decide on
employment and sales, voters’ behavior and
setting of tax policy.
• (b) Managerial economies – the application of
microeconomics to managerial issues (a scope
more limited than microeconomics).
• (c) Macroeconomics – the study of aggregate
economic variables directly (as opposed to the
aggregation of individual consumers and
businesses), e.g., issues relating to interest and
exchange rates, inflation, unemployment, import
and export policies
 Profit Maximisation
A majority of the organisations regard profit
maximisation as the sole criteria for their
existence.

The primary motivation of such organisation is to

increase profits…ex (colgate, Britannia) (Titan)

Maximising profits involves maximising revenues

while simultaneously minimising costs.
Thus, any managerial decision which is able to
increase revenue without a proportionate rise
in costs or can reduce costs without a fall in
revenue, will increase profits.

Profit maximisation in its most lucid connotation

means the generation of the largest absolute
amount of profits over the time period being
analysed – short – or long-run While short run
is the period where at least one factor of
production is constant, in the long-run all the
factors are variable.
A company ability to control its costs varies
depending on the time it has to react. As the
time increases, the proportion of variable costs
also increases.

In the short-run some costs are fixed but in the

long run , all costs are variable. The company
must recover all its fixed costs whether or not it
produces any output.

It should continue producing the output , if it can

sell it at a price that covers the additional
variable cost that it will have to incur for
production.
• A printing operator operating one printing press
on a one year lease. He employs three workers
on a one-day contract.

• While the one year lease rental for the press is

Rs.50,000. Each worker must be paid Rs.80
per day. The cost of paper, ink, electricity and
other miscellaneous expenses for printing one
book is Rs.100. On any given day, besides the
cost of the press, the cost of the workers is also
fixed since they have already been employed.
For the following day, the cost of the press remains fixed
but the wage cost of the workers is variable, as the
one-day contract can be allowed to lapse.

Similarly for the following year, all the costs of the printer
become variable since then the printer has the option
of not renewing the lease on the press and not
employing any worker either.

Now, suppose the printer receives an order in the short

–run , for printing books worth Rs.400. This will be
sufficient to cover costs of the worker the raw material
and miscellaneous expenses and also contribute
Rs.60 to the fixed overheads, which have to be paid
regardless of the order.
In this case, the printer should accept the order.

If however, the worth of a day’s job is less than that of Rs.340,

then the printer should not take up the order, since he will be
better off not hiring any worker or spending on raw material
and other expenses and letting his press remain idle.

In the long-run , in this case in a year, all the printers costs are
variable.

Therefore, he should get out of the business unless he expects

to generate enough revenue to cover the costs of the printing
press, workers, raw material, other expenses and the capital
involved in the business
In the short-run , a firm can only produce more
output by working on its fixed factor harder.

In our example, if the printer were to receive a

huge order to be completed the next day,
there would not be enough time to increase
the number of presses.

The only way to meet the new demand would

be by increasing the number of workers.
In the long-run, however, the firm can alter
both- the fixed factor and technology.
• A firms choice of technology will determine the
cost of production for different levels of output.

• Besides, achieving the lowest unit cost for any

given level of production, the other aim of profit
maximization is to earn the highest possible
revenues.

• The extent of profits for a given level of costs

depend upon the revenues that a firm can
achieve, which in turn is a function of the
consumers willingness to pay for a particular
product.
How much a consumer is willing to pay will
depend on his income, tastes and also on the
price of related goods.

The maximum price that a consumer is willing to

pay for one more unit of a particular good is
known as the reservation price.

A firm must price its product in such a way that

the nth ranked consumer pays just this
reservation price for the nth unit of the output.
Given a choice, any firm would want to charge the
reservation price from every consumer. But this
seems unlikely because it can usually charge
only a single price for all the output it sells.

Thus in order to sell to the nth consumer , it must

sell to the n-1 consumers at a price below what
they will actually be willing to pay.

In other words, if a firm lowers its price to expand

its market by one additional consumer, it loses
the value of price reduction to the last customer.

The net of these two values is known as the

marginal revenue.
It represents the change in total revenue
due to the sale of one additional unit.

While each additional unit brings in

additional revenue, it also increases the
firm’s cost. This increase in the total cost
due to the sale of one additional unit is
known as marginal cost.
• Marginal revenue is the increase in
revenue from selling one more unit of a
product. It differs from the price of the
product because it takes into account the
effect of changes in price.
• For example if you can sell 10 units at
Rs.20 each or 11 units at Rs.19 each, then
your marginal revenue from the eleventh
unit is (10 × 20) - (11 × 19) = Rs.9.
The concept is important in microeconomics
because a firm's optimal output (most
profitable) is where its marginal revenue
equals its marginal cost: i.e. as long as the
extra revenue from selling one more unit is
greater than the extra cost of making it, it
is profitable to do so.
Ideally, the firm must choose a price-output
combination that yields the highest revenue at
lowest cost, for maximising profits.

As long as the marginal revenue exceeds the

marginal cost, it will be worthwhile to add that
extra customer as then the overall profit will
increase.

Once the marginal cost equals the marginal

revenue, the last consumer makes no
additional contribution to the profits of the firm.
• The same conclusion can be reached
mathematically by constructing a model.
The model of profit maximisation is based
on the following assumptions.

• The firm is owned by a single person

• The objective of the firm is profit
maximisation
• The operating market conditions are given
to the firm
• The firm acts rationally to achieve its
objectives.
Since, profit is the excess of total revenue
over total cost
л = TR - TC
Where л is the profit of the firm. TR is the
total revenue and TC is the total cost.

Since both TR & TC are functions of output,

that is

TR = f1 (Q) and TC = f2(Q)

Л = f1 (Q) - f2(Q) = f3(Q)
Thus, profit is also a function of output
• Profit Maximizing Case
• two break even points - only normal profit
is earned at these points
• total revenue is a straight line
• total cost changes according to law of
diminishing returns
• everything inside two break even points is
profitable
• the most profitable output is at the point
where the difference between total
revenue and total cost is greatest
Basic concepts of managerial economics

The various decision making toold and

techniques provided by managerial economics
are based on some important concepts. The
three most vital concepts are – opportunity
cost, marginal analysis and discounting.
 OPPORTUNITY COST
Opportunity cost of a decision is the cost of
sacrificing the alternatives to that decision.

The question of sacrificing arises because of the

fundamental economic problem of scarce
resources which forces the manager to choose
the best out of the available alternatives.

Choosing the best automatically means leaving

behind all the remaining alternatives.
Opportunity cost confronts us at every point in
life. But, most of the times, we don’t take this
cost into account when making decisions.

For example, a shoemaker making chappals

instead of shoes and sandals.

Even when a person decides to invest his money

in the debenture of a company, he compares
the returns on his investment with what he
could have earned if this money was kept in a
bank as fixed deposit.
 Marginal Analysis
• Economists look at how costs and benefits change as there are
small changes in actions.  We call this marginal analysis, and it
is perhaps the key concept in economic analysis.

• Marginal Analysis is concerned with finding out the change in

the total arising because of one additional unit.

• In any case, be it a firm deciding whether or not to expand

production, a student deciding if another beer is a good idea, or
a professor choosing to give an extra exam, optimal
performance requires that benefits and costs be equilibrated on
the margin.

• What this means is that if the additional benefit exceeds the

additional cost, take the action. Keep taking it as long as the
benefit exceeds the cost, and to ensure that all excess benefits
(those that exceed costs) are accrued, do it until for the last
action, the benefits just equal the costs.
• The benefits from the last action (such as unit
of production or consumption) are termed
marginal revenue, and the costs from that
action are termed marginal costs

• In 1990, the National Aeronautics and Space

Administration (NASA) launched into orbit the
Hubble Space Telescope, a new orbiting
telescope that by being in space avoided
atmospheric distortions from astronomical
observations. Astronomers expected vast new
gains and insights in their scientific
explorations.
• Unfortunately, someone goofed. While being
tested after being in orbit, scientists and
engineers at NASA discovered some flaws in
the mirrors used in the telescope that
significantly diminished the ability of the
telescope to gather signals from deep space.
The scientists were devastated, but
immediately set upon ways to rectify the
problem. Of course the solution was costly.

• Politicians were outraged, some calling the

Hubble Space Telescope a $2 billion debacle.
There was a strong movement to deny any
more funds to the project, since NASA had not
gotten it right initially. But marginal analysis
reveals a much different perspective.
The $2 billion or so dollars already spent on the Hubble
Telescope did not matter. What was relevant at that
point was what were the gains and losses from fixing
the problem or leaving the telescope as it was.

In its flawed state, the Hubble Telescope could still

perform many useful and interesting scientific
functions. Corrected, it could perform more.

The only relevant question at that point was whether or

not the additional scientific discoveries that would
come from fixing the problems would be worth the cost
of the repairs. The initial expenditure to build and
launch the Hubble Space Telescope did not matter
anymore.
• The Mathematics of Marginal Analysis
• When we do marginal analysis we are seeing how one thing
changes when there is a small change in something else. 
Relationships between different variables are expressed as
functions.  We write y=f(x) to mean that the variable y depends
in some clear way -- the function -- on the value of variable x. 
Examples of functions we might see are:
 
• y=3x

• y=4x2

• y=log(x)

• y=ax2+bx+c where a, b and c are parameters

• y=1/x
• We can also have a function of more than one
variable.  For example, the variable y can be a
function of variables x, z and w.  Common examples
are:
• y= x+z+w

• y=2x2+6wz

• y=log(x)+z+w2

• y=ax2+bx+cw+dxw+fw2
where a, b, c, d and f are parameters

• y=1/x+1/w
 Marginal Analysis (contn’d)

Total revenue is the total money received

from the sale of any given quantity of output.
The total revenue is calculated by taking the
price of the sale times the quantity sold, i.e.
total revenue = price X quantity.

Quantity Total
Price Revenue
10 14 140
12 13 156
Average Revenue

Average Revenue is obtained by dividing the

total revenue by the number of units of
quantity sold.
• Revenue is the income generated from the
output produced by firms and then sold in
goods markets. It is also known as sales
turnover.

• The revenue the firm can create depends on

the strength of demand for the products they
are supplying - in other words how much output
can be sold at a given price.

• TOTAL REVENUE = Price per unit x Quantity

sold ( TR = p x q)
AVERAGE REVENUE = Total revenue
divided by output

MARGINAL REVENUE = the change in

total revenue as a result of selling one
extra unit of output.

If the average revenue curve is downward

sloping then marginal revenue will lie
below AR. In fact MR cuts the x-axis at
half the distance from the origin from
where AR cuts the origin.
TOTAL REVENUE is maximised when marginal
revenue = zero
When the demand curve (AR) is perfectly
elastic, AR = MR and total revenue will rise at a
constant rate as price per unit increases.

• Most firms face a downward sloping demand

curve for their products. As AR falls, MR will
fall as well (price has to be lowered to sell
additional units). Total revenue will rise at a
decreasing rate (see bottom right diagram) until
marginal revenue is zero. At this point (MR=0),
total revenue is maximised. 
• The area shaded in yellow shows the maximum
total area underneath the demand curve AR.
 Discounting Principle

Almost all managerial decisions relate to the

future. The value of money today is not the
same as it will be at a later point of time.
Anything that is received later always
involves an element of risk.

A rupee received today is more valuable

than a rupee that will be received later.
This is known as the time value of money.
Suppose a person is offered a choice to make
between a gift of Rs.100/- today or a Rs.100
next year. Naturally, he will choose Rs.100
today. This is true for two reasons :-

- The future is uncertain and there may be

uncertainty in getting Rs.100/- if the opportunity
is not availed of

- Even if he is sure to receive the gift in future,

today’s Rs.100 can be invested, so as to earn
interest say as 8%, so one year after it will
become RS.108
 Equi-Marginal Principle

• This principle deals with the allocation of

an available resource among the
alternative activities. According to this
principle, an input should be so allocated
that the value added by the last unit is
same in all cases.

• This generalisation is called the equi-

marginal principle.
Suppose a firm has 100 units of labor at its
disposal. The firm is engaged in four
activities which need labor services A, B ,
C and D. It can enhance any one of these
activities by adding more labor but only at
the cost of other activities
Demand and Supply

Economics studies how society allocates the

limited resources of the earth to the
insatiable appetites of humans.
Supply and demand are the forces at work.
At what is referred to as the equilibrium
(E), the market price allows the quantity
supplied to equal the quantity demanded.
Suppliers are willing to sell, and consumers
are willing to buy. Supply equals demand
for a price.
That in a nutshell, is the basis of all economic
theory.

For example, lets take a look at the local pub,

Porth Tavern which brews its own beer, spud
beer. Imagine you are a fosters drinker and the
bar is running a 25 cents special discount on
mugs of Spud beer.

The owner has ten kegs on hand, but feels if he

were to charge the usual dollor per mug, he
might be able to sell one or two kegs.
You like Fosters, but at 25 cents you decide to try
the cheaper brew. Here, in this bar, the
“invisible hand” of economics is at work. At the
“right” price, there is a demand for the ten kegs.

supply

Mug price
.25 demand
cents

0 2 4 6 8 10 14 16 18 20
The graph shows that as the price per mug
increases, the brewery would be willing to
produce more , but people would be less willing
to buy.

Generalising from this simple relationship to an

entire economy, aggregate supply (AS) equals
aggregate demand (AD) at an equilibrium price
and level of economic output. The graph is
similar to beet graph, the same relationship
holds, but the elements measured constitute a
much more serious MBA subject.
 AS

Price Level
(P)
P AD

Economic Output (Y)

0 2 4 6 8 10 14 16 18 20
Level of Economics : MICRO OR MACRO

Micro economics deals with the supply and

demand equation of individuals, families,
companies, or industries. The Fosters versus
Spud beer competition was an example of
Micro-economic battle.

Macro-economics , on the other hand, concerns

itself with the economies of cities, countries or
the world as shown in the second graph. Simply
put, “micro” economics deals with “small”,
specific situations; “macro” economics loos at
the “big” picture of entire economies.
 Micro Economics
Micro-economics is less glamorous than
macro-economics, but it is a little more
practical.
Since most of us are not likely to have a
macro-effect on a whole economy , we will
concentrate on a few basic concepts that
make-up micro-economic knowledge.
 Opportunity Costs - Revision
Because our appetite for goods and services
are insatiable, decisions have to be made
to determine how to allocate limited
resources.

Most often, the increase in production of a

good or service requires that a cost or
sacrifice be incurred. Economists call
these costs opportunity costs.
For example, in 1992 the demand for Harley-
Davidson motorcycles had the company’s
factories operating at 100 % of capacity.
Harley controlled 60% of the big-ticket, big-bike
market, and management was forces to decide
how best to allocate limited production capacity
to satisfy demand.
They chose to produce several models for sale in
the United States and abroad.
As a result, Harley Davidson, incurred a
significant opportunity costs because the
company decided not to devote its entire
capacity to its most expensive and profitable
models for export to Japan.
Had Harley tried to maximise short term profits,
it would have risked alienating the domestic
market of devoted bikers – the very group
that helped create the Harley mystique that
the Japanese are buying.

Opportunity cost, therefore, is the cost of

choice, when output, time and money are
limited.
 Marginal Revenue and Cost - revision
A concept closely associated with opportunity
cost is marginal revenue and marginal cost.

Companies are motivated to maximise total

profits by maximising revenues and minimising
costs. If a business has the opportunity to sell
even a single additional unit at a profit, it should
produce it. The Marginal Revenue (MR) from
sale should exceed the marginal cost (MC) to
produce.
Enterprises should continue to produce until their
MR=MC. At that point of equilibrium the
marginal profit on the next unit sold will equal
zero.

No profits are left on the table. Past that level, the

marginal revenue of each additional unit sold
decreases and the marginal cost increases.

Experience tells us that more units businesses try

to push on the market, the less the market is
willing to pay for these goods.
The cost of producing one additional unit is
minimal. But if there is no excess capacity and
a company wants to produce more units, new
workers will need to be hired, new equipment
purchased and a larger factory leased or built.

Therefore, once a factory reaches capacity , the

marginal cost of producing one additional unit
increases beyond the cost of last unit produced.

In the case of a cattle rancher, ram singh, the

marginal cost of adding a sheep to the herd is
minimal. Fences still have to be mended and
the pasture maintained.
Since he is a rational decision market, Ram Singh
will add cattle to the point that the marginal
revenue from the same of an additional sheep
will cover these marginal costs of raising this
sheep. (MR=MC).

If the cost of raising one additional unit becomes

higher than the current market price, then Ram
Singh will stop adding sheep to his herd.
 Marginal Revenue and Cost Equilibrium

MC

Price (P) E
P
MR=P

Q
Quantity Produced (Q)
Why the demand curve is flat rather than
downward sloping, as in the case of other
demand curves. It is because the price of meat
is determined in a competitive auction.

The few additional head of cattle that Ram Singh

might bring to the market will not affect the price
that is determined by the output of thousands of
ranchers and meat processors.

But if Ram Singh had a corner on the meat

market , or a monopoly then presumably he
would always produce and sell at the point
where MR=MC.
In that case his marginal revenue curve would
slope downward to the right as in the instance
of the standard demand curve shown in the
beer illustration.

The marginal cost and revenue concepts would

also hold true for a cookie factory manager
faced with a large special order.

Imagine yourself in his apron. The customer

wants to pay 1.00 Rs. Per dozen for 100
dozens to be sold at the local mela. You have
some excess capacity and so you go to your
Accountant and ask what your cost is to
satisfy this order. She asserts that it would
cost Rs.1.45 per dozen. She gives you this
breakdown as proof.

Cookie Batter Rs.0.80

Labor Rs.0.25
Factory utilities Rs.0.20
Factory upkeep Rs. 0.20
----------
Total cost Rs.1.45
From that information you can see that the only
marginal cost of running the automated cookie
production line is the extra batter.

The machine operator would be there anyway,

and the large oven would be on anyhow. The
factory would continue to require the usual
maintenance.

The factory manager would welcome the order

because he can make a marginal profit.
• As shown in the sheep and cookies examples,
“marginal” costs and revenues are critical in
making “marginal” pricing and production
decisions.

• However, to evaluate profitability of an entire

business , rather than one transaction , total
revenue must exceed total costs to make a
bottom line company profit.
• Before, we analyse demand in order to forecast
it, it is very important to understand the basis of
consumer demand i.e why , when and how
much does the consumer purchase.

• Utility i.e the want satisfying quality of a good or

service, is the prime factor that generates
demand.
• Utility is the terms used to describe the value of
a product to a consumer.
• Marginal Utility (MU) means the usefulness or
utility of having an additional unit of a product.
At some point a buyer is fully satisfied, and an
additional unit is of no value.

• Going back to the beer example, suppose you

are looking to forget whatever troubles you
have and you order one more beer at Port
Tavern. A second beer would be welcome and
infact would be of great Marginal utility. Five
hours later you have had twelve beers, played
bowling, danced and in the process forgotten
your troubles.
At his point, an extra beer would be of little
value.

THE MARGINAL UTILITY OF THE

THIRTEENTH BEER IS NEGLIGIBLE.
 Concept of demand (revision)
Demand for a commodity implies
• Desire to acquire it
• Willingness to pay for it
• Ability to pay for it

• Mere desire to buy a product is not

demand. A miser’s desire for this ability to
pay for a car is not demand because he
does not have the willingness to pay for it.
Similarly a poor man’s desire for and his
willingness to pay for a car is not demand
because he lacks the necessary purchasing
power.
One can also conceive of a person who
possesses both the will and purchasing power
to pay for a commodity, yet this is not demand
for that commodity if he does not have desire to
have that commodity.
Demand for a commodity refers to the quantity of
the commodity which an individual household is
willing to purchase per unit of time at a
particular price/
 Types of demand
• Direct and indirect demand

Demand for goods that are directly used for

consumption by the ultimate consumer is
known as direct demand. Demand for all
consumer’s goods such as bread, tea,
readymade shirts, scooters, houses is direct
demand.

Indirect demand is the demand for goods that are

not used by consumer’s directly. They are
used by producers for producing other goods.
Examples of indirect demand are demands for
machines, tools, coal and any raw material.

While direct demand depends primarily upon the

consumer’s income, indirect demand depends
upon the concerned producer’s output.

In the above example, if cloth is a consumer

good, then its demand will depend on the
consumer’s income, while if it is used by a
garment manufacturer, then its demand would
depend for readymade shirts and trousers.
Derived and autonomous demand
The goods whose demand is not tied with the
demand for some other goods are said to have
autonomous demand, while the rest have
derived demand.

Thus, while demand for tyres is derived since it

depends upon the demand for vehicles, the
demand for milk or vegetables is autonomous.

However, since almost all products depend on

others to some extent, the difference between
the two is of more degree.
Durable and Non-durable goods demand

Durable goods are those that can be used more

than once, over a period of time, as against
non-durable goods that can be used only once.
Both producer and consumer goods can be
durable and non-durable.

Durable goods are used while non-durable goods

are consumed. Amoung producer’s goods while
machines, tools, etc are non-durable.
Consumer’s goods such as bread, jam etc are
non-durable while car, readymade garments
are durable.
Firm and Industry Demand

As the name indicates, firm demand is the

demand for the product of a particular firm. On
the other hand , demand for the product of a
particular industry is known as industry
demand.

For example. Demand for pens is an industry

demand, while the demand for Parker pens is a
firm demand. Similarly, demand for Colgate
toothpaste and toothpaste in general are firm
and industry demands respectively.
• Total Market and Market Segment Demand.

• Demand analysis requires not only the total

demand for a product but also a break-up of the
demand for the product in different parts of the
market.

• The market may be segmented on the basis of

age, geographical region etc. Thus while the
demand for kwality ice cream in India is Total
Market Demand, demand for Kwality ice cream
in Rajasthan or demand for Kwality ice cream
by women is a market segment demand
REVISION
Variables
Variables are things which change and can take a
set of possible values within a given problem.

A constant or parameter is a quantity which does

not change in a given problem.

For example Y = a +bx

Here ‘a’ and ‘b’ are constants and ‘X’ and ‘Y’ are
variables.
X is the independent variable while Y is the
dependent variable.

X can assume different values and this will cause

Y to assume different values also.

Function

An example of a function is Q = Q (P)

It has the following characteristics :-

 Q = Q (P)
It shows the relationship between two variables Q
& P, such that for every value of P there is only
one value of Q.

These are the basic building blocks of economic

models.

The function D = D(P) is a demand function and

its graph with price on one axis and quantity on
the other will give a demand curve.
 D = D(P)
P is the independent variable and D is the
dependent variable.

It indicates the cause-effect relationship between

variables ( P is the cause variable, while D is
the effect variable)

A function can be represented by means of a

table or graph.
Graphs of functions can take different forms,
depending on the form of the function.

Three functions frequently used in managerial

economics involving a single dependent
variable are given below :
Q

Linear

Q = a-bP

A = OA

P B = OA/OB
o B
 Q Quadratic

A = a-bP + CP2

a = OA
A
C > 0
O P
Q
Quadratic

Q = a + Bp – CP2
A
a = OA

o P

Cubic

Q = a + bP + cP2 + dP3

a = OA
• Utility Analysis

• The Utility analysis was developed by Alfred

Marshall to explain consumer demand. This
approach was based on the fact that utility is
quantifiable i.e it can be measured in some
units. The unit for measurement of utility is
known as util.

• Thus for example, it can be said that ice cream

has 10 utils while Rasgulla has 6 utils. This
holds true for a person who likes ice cream
more than rasgulla.
• Since utility can be measured in specific units ,
so it can also be added. We thus have total
utility and marginal utility.

• Total utility , which is a measure of the overall

satisfaction, is defined as the total satisfaction
derived from the consumption of all the units of
a good or service.

• Marginal utility, on the other hand is the change

in total utility when one additional unit of a good
or service is consumed. Thus, if the utility
derived from the consumption of 1,2,3….n..
Units of goods or services are U1, U2, U3….Un
then

Total Utility for 1 unit TU1 = U1

for 2 units TU2 = U1 + U2
for 3 units TU3 = U1 + U2 +U3
for ‘n’ units TUn = U1+U2 +U3 +..Un

Marginal utility for the 2nd unit MU2 = TU2 – TU1

for the 3rd unit MU3 = TU3-TU2
Assumptions of Utility Analysis
1. Utility is cardinal
2. Utility being quantifiable is additive
3. Various units of a commodity consumed are
homogenous. For example, if the case relates
to the consumption of 200ml bottles of soft
drink , then all the units consumed must be
200ml bottles of the same soft drink
4. There is no time gap between the
consumption of successive units. The
consumer goes on consuming the units one
by one, without any break
5. The consumer is rational, i.e he has perfect
knowledge and maximises utility.
6. The consumers income is limited and
constant
7. The tastes and preferences of the consumer
remain unchanged
8. The marginal utility of money is constant.
Here the marginal utility of money is the
change in total utility that results from
spending one additional unit of money.
 Revision
In most economies, prices determine what, how, and for
whom goods are produced. 

Firms will produce whatever goods can be sold at a

profitable price and will choose resources on the basis
of what prices must be paid to employ them. 

The consumers willing to pay the price will be the ones

for whom goods are produced.  Given the importance
of prices, we need to know how they are determined. 
Why are some high and others low?  Why do some
rise while others fall?  It’s all demand and supply.
• Demand
 
• Economists use the term demand to indicate
willingness to buy.  While the demand for a product
depends upon many different factors, one obvious
determinant is price.  Price has a negative effect on
willingness to buy.  All else equal, as the price of a
product falls, the quantity demanded will rise. 
 
• It is often useful to illustrate these relationships
graphically.   We draw a demand curve to show the
relationship between the price of the good and the
quantity that consumers are willing to buy.
• For example, suppose people are willing to buy 20 numbers of
strawberries at a price of Rs.20, but are willing to buy 30 if the price falls
to Re10. 

•  Because a change in price will always push the quantity demanded in

the opposite direction, all demand curves will have a negative slope.

Price

20

10

Quantity of Strawberries
20 30
• The price of good is not the only factor that impacts
willingness to buy.  Other important factors include:
•  1.   consumer tastes and preferences (or the
perceived value of the product)
• 2.  consumer income
• 3.  prices of substitute and complementary goods

• Note: Substitute goods (like corn and green beans);

complementary goods (like cars and gasoline).
• 4.  consumer expectations
• 5.  number of potential consumers in the market or
population
These factors often are called demand shifters. 
If any of them changes, the entire demand
curve will move or shift.  

For example, suppose new research indicates

that eating strawberries will make you more
attractive.  Will consumers react to this news? 
Of course.  It will change the perceived value of
strawberries and increase the quantity of
strawberries people are willing to buy at every
price. 
Using the above numbers, suppose this new
research triples the quantities people are willing
to buy at each price. 

In other words, consumers are now willing to buy

60 nos (rather than 20) at the Rs.20 price and
90 nos (rather than 30) at the Re.10 price.

The demand curve will shift to the right

Price

D1 D2

20

10

20 30 60 90
Quantity of Strawberries
the original demand curve (D1) has shifted to
become a new demand curve (D2).

• Supply
•           Supply
indicates willingness to sell.  Like demand,
the supply of a product depends upon many different
factors and, like demand, one obvious factor is price. 

• However, while high prices discourage buyers, they are

likely to encourage sellers. 

• Price has a positive effect on willingness to sell.  All

else equal, as the price of a product rises, the quantity
firms are willing to sell will rise as well. 

         
• A supply curve illustrates the relationship
between the price of the good and the quantity
that firms are willing to sell. 

• For example, firms might be willing to sell 600

Sacks of wheat at a price of Rs.300, but be
willing to sell 900 Sacks at a price of Rs.400. 
• Because a change in price will push the
quantity supplied in the same direction, supply
curves will have a positive slope.
Price

Supply Curve
400

300

600 900 Quantity

• Price is not the only factor that impacts
willingness to sell. Other important factors
include:
•  
•             1.         cost of inputs
•             2.         available technology
•             3.         profitability of other goods
•             4.         number of sellers in the market
•             5.         producer expectations
•            
•           These factors are supply shifters.  If any
of them changes, the entire supply curve will
move or shift. 
For example, suppose new technology lowers the
cost of growing wheat. 
How will farmers react?   

The new technology increases the profitability,

and therefore the willingness to sell at every
price.  Suppose the new technology doubles
the quantities people are willing to sell at each
price.  In other words, firms are now willing to
sell 1200 sacks (rather than 600) at the Rs.300
price and 1800 Sacks (rather than 900) at the
Rs400 price.  The supply curve will shift to the
right.
Price

S1 S2

400

300

600 900 1200 1800

Quantity
the original supply curve (S1) has shifted to
become a new supply curve (S2).
• Equilibrium
•  
•           At last we return to the initial question: how does
a market economy determine prices?

• The answer is that every market has a stable

equilibrium where the quantities supplied and
demanded are equal. 

• For Example If you have supplied 100 nos of

strawberries, but consumers are willing to buy only 70,
what will happen?  How do real-world firms react when
they are faced with products sitting on their shelves
that no one wants to buy?  They have a sale.  They
lower the price.  After all, it’s better to sell products at a
reduced price than to not sell them at all.  In other
words, if the quantity supplied exceeds the quantity
demanded (a surplus), prices will fall.
Change the example.  This time, suppose consumers
are clamoring to buy 100 nos of strawberries, but you
have only 70 to sell. 

Might you raise the price?  In fact, consumers probably

will offer a higher price. 

If you were one of the 100 potential customers, how

could you make sure that the firm sold the scarce
strawberries to you rather than someone else?  Offer
to pay a higher price!  In other words, when the
quantity demanded exceeds the quantity supplied (a
shortage), prices will rise.  Prices will be stable or in
equilibrium only if the quantities supplied and
demanded are equal.
Since both supply and demand curves are drawn with price
on the vertical axis and quantity on the horizontal axis, we
can put both curves on the same graph. 

  The point at which the curves cross or intersect is the

equilibrium. 
 
         
• In the example below, P1 is the equilibrium price
and Q1 is the equilibrium quantity.  Any price
above P1 (such as P2) will create an excess supply
or surplus.  The quantity supplied (as shown by
the supply curve) will exceed the quantity
demanded (shown by the demand curve).  In light
of the surplus, firms will lower price to P1 to sell
their extra goods.
•  
•           Any price below P1 (such as P3) will create
an excess demand or shortage.  The quantity
demanded will exceed the quantity supplied. 
Because of the shortage, firms will soon discover
that they can sell all they have even at a higher
price.  As a result, the price will rise to P1.  In the
long run, the price always moves to the
equilibrium.
• The following will cause the demand curve to
shift to the right  

• 1.         an increase in consumer income

• 2.         an increase in the price of a substitute
good
• 3.         an increase in the number of potential
consumers in the market
However, some families might perceive of
burgers as an inferior good.

They might look at the increase in income as an

opportunity to eat fewer burgers and shift to
more expensive foods instead.

  If so, the demand for the burgers will shift to the

left and both the equilibrium price and quantity
will fall.
Micro Economics – The study of individual,
family, company and industry economic
behavior

Macro Economics – The study of the behavior of

entire economies

Equilibrium – The point at which the quantity

supplied equals the quantity demanded and a
mutually agreeable price is determined
Marginal Revenue and Cost – The added
revenue and cost of producing and selling
one additional unit.
• Price Elasticity of Demand

• Buyer’s responsiveness or sensitivity to

changes in price is called elasticity.

• For Example, Brand managers at Proctor &

Gamble, for example, want to know how a price
change will affect demand for their brand of
soap. Production foremen at Ford Motor
Company want to know how price changes will
affect their production requirements
If consumers are very sensitive to price changes,
their demand is termed elastic.

Consider the example of McDonalds while it

introduced burger for Rs.20 and softy ice cream
cone for RS.7. Consumers responded strongly
purchasing more of these items.

When consumers are not sensitive to prices,

economists call their demand inelastic. Their
purchasing behavior does not change with price
changes. Necessities such as medical services
or cigarettes fall into the inelastic category.
Hard-core nicotine addicts accept cigarette price
increases.

The price elasticity of consumer demand for a

product is very important to consider when
pricing a product.
 Price, Income
and Cross Elasticity
 Elasticity – the concept
• The responsiveness of one variable to
changes in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
 Elasticity – the concept
• If price rises by 10% - what happens to
demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent to which
demand will change
 Elasticity
• 4 basic types used:
• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity
 Elasticity
• Price Elasticity of Demand
– The responsiveness of demand
to changes in price
– Where % change in demand
is greater than % change in price – elastic
– Where % change in demand is less than %
change in price - inelastic
 Elasticity

The Formula:
% Change in Quantity Demanded
___________________________
Ped =
% Change in Price

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic
 Elasticity
Price (£)
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded
 Elasticity
Price Total revenue is price x
The importance of elasticity
quantity sold. In this
is the information it
example, TR = £5 x 100,000
provides on the effect on
= £500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5

Total Revenue

100 Quantity Demanded (000s)

 Elasticity
Price If the firm decides to
decrease price to (say) £3,
the degree of price elasticity
of the demand curve would
determine the extent of the
increase in demand and the
change therefore in total
£5 revenue.

£3

Total Revenue
D
100 140 Quantity Demanded (000s)
Formula for Price Elasticity of Demand
ep = % change in quantity demanded
-----------------------------------------
% change in price

Where,

% change in quantity demanded

= New quantity - Old Quantity
------------------------------------ x 100
Old Quantity
And % change in price
= New Price – Old Price
------------------------------- x 100
Old Price

Let P = Old price

Q = Old quantity
▲Q = New Quantity - Old Quantity
▲ P = New Price – Old Price
 ▲Q
----- X 100
Q
eP=(-)--------------- ▲Q P
▲P = ------ . ---
----- X 100 ▲P Q
P
What Does Law Of Demand Mean?
A microeconomic law that states that, all
other factors being equal, as the price of a
good or service increases, consumer
demand for the good or service will
decrease and vice versa. 
• Exceptions?
• The law of demand says that as price goes up, demand falls.
Can you think of exceptions, in which raising price could
actually increase demand for a good? Economists have
thought of three possibilities.
• Inferior goods. The classic story is that 200 years ago, if
your income went up, you would consume more meat and
less potatoes. When you consume less of a good as income
goes up, we call it an inferior good. Two hundred years ago,
potatoes were an inferior good.
• If you eat mostly potatoes to begin with, and the price of
potatoes goes up, the reduction in purchasing power
effectively lowers your income--so that you cannot afford as
much meat, and you might even consume more potatoes!
• Usually, even with an inferior good, as the price goes up you
consume less of it. The inferior good has to be a major part of
your consumption basket in order for the possibility to arise
that an increase in price could increase demand.
• Snob appeal. Thorstein Veblen, an economist of the late 19th
century, suggested that some people consume in order to
impress others. Think of a luxury sports car, for example. It
might be the case that the higher the price of such a car, the
more it will appeal to people trying to show off.
• Signalling. The 2001 Nobel Prize in economics went to Joseph
Stiglitz, George Akerlof, and Michael Spence, who analyzed
situations where some people know more about the quality of a
good than others. One of their theories is that When buyers do
not know the true quality of a good, they may use price as a
"signal" of quality.
• For example, if they see two batteries in a store, they may
assume that the higher-priced battery lasts longer. In that case,
a higher price could increase demand.
• All of these exceptions may be interesting theoretical
possibilities. However, none of them is found often enough in
practice to make economists question the law of demand. For
all practical purposes, it is safe to say that when the price goes
up, demand goes down.
• The Determinants of Demand
• (1) Income
• Consider the demand for new homes. You want
a new home and choose one you like. The price
is Rs.1,000,000. You don't buy. One reason is
that your income is not large enough to be able
to afford this amount. Therefore, income must
be one of the factors that affect the demand for
a given product. Normally, we expect that as
one's income rises (falls), the demand for a
product will rise (fall). Because we normally
expect this to be true, a good for which this
statement is true is called a normal good.
occasionally, we shall encounter a good for
which the statement is not true
• These are called inferior goods; for these
goods, as income rises (falls), the demand
for the product falls (rises). One example of
an inferior good might be black and white
television sets. People buy them only because
they cannot afford a color television set. As
income rises, people buy fewer black and white
television sets. Another example of an inferior
good might be riding the bus. As income rises,
people are less likely to use the bus and more
likely to own an automobile. Tailoring and
shoemaking services may be other examples.
As income falls, people are more likely to have
their clothes and shoes repaired; as income
rises, they are more likely to buy new ones.
• Knowing that as income rises, the demand will rise is
useful information. But, as with the price of the
product, it is not enough information. A company or a
government agency wants to know how much the
demand will rise if income rises by a certain percent.
In particular, they want to know the income elasticity
of demand, given by the formula:
• percentage change in demand for a product
• ----------------------------------------------------------------
• percentage change in income
• In this case, we are measuring how greatly buyers
respond to a change in their income. If the number is
positive, we know that this is a normal good
(income and demand both rose). If the number is
negative, we know that this is an inferior good
(income rose and demand fell).
• Again, we commonly divide at one. If the
number is less than or equal to +1, the
product is called a “necessity”. This means
that if income falls, the demand falls very little
--- because the product is needed. If the
number is greater than 1, the product is
called a “luxury”. This means that if income
falls, the demand falls greatly --- because the
product is not needed
Determinants of demand
(contd)
• 2) The Price of a Complement
• Return now to your decision to buy a new home. Assume that you are willing
to pay the price and have sufficient income. What other factors might enter
into your decision?

• One factor might involve the method you will use to pay for this home ---
borrowing money. The price of borrowing money is called the interest rate.
The interest rate is one example of the price of a complement. A
complement is a different good that goes together with the one under
• consideration.

• Homes and borrowing money tend to go together. So do bread and butter,

coffee and sugar, gasoline and automobiles, homes and furniture, peanut
butter and jelly, and many other examples. What happens to the demand
for new homes if the interest rate rises?

• The answer, of course, is that it falls. When interest rates rise, people are
less likely to borrow. If they do not borrow, they will not buy the homes. It is
also likely that the demand for butter will fall if the price of bread rises, the
demand for automobiles will fall if the price of gasoline rises, and so on.
Therefore, our relationship is: if the price of the complement rises (falls),
the a demand for the product (homes) falls (rises)
• 3) The Price of a Substitute Good
• Complements are different goods that are related to the one we are
considering. There is another kind of relationship: the products may be
substitutes. Substitutes are different goods that compete with the one
under consideration.

• Coca-Cola and Pepsi Cola are substitutes, as are butter and margarine,
American cars and Japanese cars, Barista and Costa Coffee, (in the fall)
and many other examples.

• In our example, the main substitute for homes is apartments. What

happens to the demand for homes if the price of apartments falls? If
apartments rented for $100 per month, more people would want to live in
apartments and fewer in homes. It is also likely that the demand for Coca
Cola would rise (fall) if the price of Pepsi Cola rises (falls), the demand for
American cars would rise (fall) if the price of Japanese cars rises (falls), and
so on.

• Therefore, our relationship is: as the price of the substitute

(apartments) rises (falls), the demand for the product (homes) rises
(falls).
• Again, knowing these relationships is important information. But
again, it is not enough. We want to know how much the
demand for a product will change if there is a given percentage
change in the price of another product.

• This is called the cross elasticity of demand and is given

• by the formula:

• Percentage Change in the Demand for a Product /

• Percentage Change in the Price of a Different Product

• Notice that this number measures how much the demand for
one product responds to a change in the price of a different
product. If the number is positive, the products are
substitutes (if the price of the other product rises, the demand
for this product also rises). The larger the number, the closer
the products are as substitutes. If the number is negative, the
products are complements (if the price of the other product
rises, the demand for this product falls). If the number is
zero, the products are totally unrelated
• One use for the cross elasticity of demand will be important
later. An industry is a group of companies that sell a
similar product.

• We speak of the automobile industry or the computer

• industry. Notice that the products are similar but not exactly the
same. A Honda Civic is very different from a Lexus and a PC is
different from a Macintosh computer.

• So how do we know which companies are in the same

industry? Are Coca-Cola and Pepsi Cola in the same industry?
• Most would say so. Are Coca-Cola and Orange Juice in the
same industry? Both are drinks and neither has alcohol. Are
Coca-Cola and beer in the same industry? Both are drinks are
both are carbonated. Are Coca-Cola and coffee in the same
industry? Both are drinks and both have caffeine. The definition
of an industry would seem quite arbitrary. To get more
precision, we will use the cross elasticity of demand.
• One possible definition is: companies are in the same industry
if the cross elasticity of demand is +1.0 or greater.
• This means that a 10% increase in the price of one product
would cause the demand for the other product to rise by 10%
or more. (The courts have used this definition in some
important court cases.)
• As we will see later, which particular companies are included in
an industry has great implications. Coca Cola was not allowed
to purchase Dr. Pepper because they are in the same industry;
however, it was allowed to purchase Minute Maid because, by
this definition, they are not in the same industry.

• For the same reason, Pepsi Cola was not allowed to purchase
Seven-Up but was allowed to purchase Frito Lay and Taco Bell.
By this definition, do you think that large business mainframe
computers and smaller personal computers in the same
industry? Why or why not? (This point had great implications in
a long court case in which the government challenged IBM.)
• 4) Tastes or Preferences
• We have thus far discussed three factors affecting
your decision to buy a home other than the price of the
home: your income, the price of complements such as
borrowing money and buying furniture, and the price
of substitutes such as apartments.
• One obvious other factor involves the fact that you like
homes. This we call tastes or preferences. It involves
the fact that there are certain psychological reasons
for liking or disliking a particular good. Our principle is:
the more (less) we like a good or service, the
greater (less) is our demand for it. So what do you
think happened to the demand for red wine when the
television show 60 Minutes reported that drinking red
wine moderately every day lowered cholesterol and
therefore lowered the risk of having a heart attack?
• (5) Expectations
• In the case of homes, we have often observed people buying
not just one home but five or six.
• This does not mean buying one in Shimla, another in J & K for
skiing, and another in Goa for surfing.

• It means several homes in the same area. Why would one do

this? One answer is that the buyer expects the price to rise
in the near future. Of course, the buyer does not know that the
price will rise. So, there is a gamble here; the buyer expects the
price to rise. These expectations affect our demand for many
products.

• For example, people commonly buy stock or foreign monies

because they expect the prices of the stock or of the foreign
money to rise soon. (Do not confuse this with the last section
where we considered how buyers respond when the price
actually does change. Here, the price has not changed; buyers
• simply expect that it will change soon.) Our principle here is: if
buyers expect the price to rise (fall), the demand rises
(falls) today
• There are other kinds of expectations one might have
that will affect the demand for products.
• If one expects that the product will soon be
unavailable, the demand will rise today. If there is a
strike in any oil and natural gas industry then expecting
that gas stations would soon be out of gasoline, buyers
rushed to stock-up. Also, if one expects that one's
income will fall, the demand for most products will
fall.
• During recessions, other people are losing their jobs or
otherwise having their incomes reduced. Even though
this has not yet happened to you, you may be worried
that it will. As a result, you may reduce your buying of
many products. As we shall see later, expectations
often become self-fulfilling prophecie
• 6) Population
• The last of the factors affecting demand is the
population (number of buyers). The market
demand is simply the sum of the individual
demands. If, at the price of Rs.200, Bill wants to
buy 2, one crate of Coca Cola, Jose wants to
buy 3, one crate of Coca Cola, and Mary wants
to buy 1, one crate of Coca Cola, then, of
course, the market demand is 6, one crates. If
Jordan becomes a buyer and wishes to buy 4
one crate, the market demand rises to 10, one
crate packs. Therefore, if there are more
buyers, there must be more market demand.
• A substitute is a product that is similar to
another product and can be used instead. For
example, butter and margarine, a bus or a taxi,
coffee and tea, gas and electricity and so on.

• A complement is a good that tends to be used

together with another related good. For
example, a DVD player and a DVD, toast and
marmalade, coffee and milk, pen and paper and
so on
Factors Influencing Supply
The major variables other than price are:

1. Money Costs of Production :

The cost of factor inputs like land, labour ,
capital has a major influence on supply. If at
any given level of output, there is an increase
in costs of production, this will reduce the
ability of producers to purchase factors of
production at any given price for their
product. In consequence, the supply curve will
shift to the left – there will be reduction in
supply.
• Inter-related supply : Some goods are in joint
supply so that variations in the amount of one
good produced almost automatically affect the
supply of by-products.

• Other goods are in competitive supply,

especially when they use a common raw
material. Thus increase in supply of cheese can
reduce supply of butter as both are made from
milk.

• Events beyond human control like good/bad

harvest , weather conditions and natural
disasters like floods.
Taxes and subsidies also have an important
effect on supply.
 Demand Forecasting
A forecast is a prediction or estimation of a future
situation. All business decisions are based on
some forecast of the level of economic activity in
general and demand for the firm’s product in
particular.

For example, the demand and sales of new

automobiles, new houses, electricity and most
other goods and services rise and fall with the
general level of economic activity.
 What is demand forecasting?
Demand Forecasting is the activity of estimating
the quantity of a product or service that
consumers will purchase.
Demand forecasting involves techniques
including both informal methods, such as
educated guesses, and quantitative methods,
such as the use of historical sales data or
current data from test markets. Demand
forecasting may be used in making pricing
decisions, in assessing future capacity
requirements, or in making decisions on
whether to enter a new market.
Forecasts can be classified into two categories :-

i) Passive forecasts

ii) Active forecasts

Passive forecast is one where prediction about

the future is based on the assumption that the
firm does not change the course of its action,
and active forecast is where forecasting is
done under the condition of likely future
changes in the actions by the firm.
 Forecasting Techniques
A number of techniques are available for
forecasting demand. Forecasting techniques
can be broadly classified into two categories

Qualitative and Quantitative techniques

 Qualitative techniques
Expert opinion method

This technique of forecasting demand seek the

views of experts on the likely level of demand in
the future. Experts are informed persons who
know the product very well as they have been
dealing with it and related products for a long
time. This personal insight is used for
developing future expectations.
 Qualitative Techniques (contn’d)
A specialized form of expert opinion is the Delphi
method. Instead of going in for direct
identification, this method seeks the opinion of
a group of experts through mail about of
expected level of demand.

The responses so received are analysed by an

independent body.
 Qualitative techniques (contnd)
Consumers Complete Enumeration Survey

This method is based on a complete survey of all

the consumers for the commodity under
consideration.

Interviews or questionnaires are used to ask

consumers about the quantity of the commodity
they would like to buy in the forecast period. All
the data is added up to arrive at the total
expected demand for that product.
 Qualitative Techniques (contnd)
Sales Force opinion survey

This method is similar to the expert opinion method. The

difference here is that instead of external experts,
employees of the company who are a part of the sales
and marketing teams are asked to predict future levels
of demand. The sales force, which has been selling
the product to wholesalers/retailers/consumers over a
period of time, is considered to know the product and
the demand pattern very well. Moreover, they being
company employees will be less likely to introduce the
element of bias in their opinion.
 Qualitative techniques
Consumer’s End Use Survey

Goods can be either producer’s goods or

consumers goods. They can be also a
combination of these tow wherein they many be
used for the production of some other
consumer goods and can also be used for final
consumption.
A commodity that is used for the production of
some other finally consumable good is also
known as an intermediary good.
While the demand for goods used for final
consumption can be forecasted using any other
method, the end use method focuses on
forecasting the demand for intermediary goods.

Such goods can also be exported or imported

besides being used for domestic production of
other goods. For example, milk is a commodity
which can be used as an intermediary good for
the production of ice cream, panner and other
dairy products.
For ex
Dm = Dmc + Dme –Im + xi . Oi + xp. Op+….+xn.On
Where

Dme = Final consumption demand for milk

Dme = Export demand for milk
Im = Import of milk
Xi = Per unit milk requirement of the ice cream
industry
Oi = Output of the ice cream industry
Xp and Op notations are similar to xi and Oi for
paneer

The equation aforementioned can be generalised

to calculate the projected demand for comm.
D = Dc + De – I +x1 . O1 + x2. O2 +…..xn.On
 Quantitative Techniques
These are forecasting techniques that make use
of historical quantitative data.

A statistical concept is applied to this existing

data about the demand for a commodity over
the past years, in order to generate the
predicted demand in the forecast period.

Due to this reason , these quantitative techniques

are also known as statistical methods.
• Trend projection method

• This technique assumes that whatever has

been the pattern of demand in the past, will
continue to hold good in the future as weell.
Historical data can thus be used to predict the
demand for a commodity in the future.

• In the trend projection method, historical data is

collected and fitted into some kind of trend i.e
repetitive behavior pattern.
• This trend is then extrapolated into the future to
get the demand for the forecast period.
Future demand through the trend method can be
found by either of the two methods

Graphical method
Algebraic method

In the graphical method, the past data will be

plotted on a graph and the identified
trend/behavior will be extended further in the
same pattern to ascertain the demand in the
forecast period.
 Past Data Projected data

Demand
Trend 2

Trend 1

2008 2009 2010 2011

2006 2007

Forecasting trends
While trend 1 is linear, trend 2 is non-linear

In the algebraic method, also commonly

known as the least square method, the
demand and time data are fitted into a
mathematical equation.
Barometric Techniques

It has been observed that despite erratic cyclical

patterns in most economic time series, the
movements of different economic variables
exhibit quiet a consistent relationship over time.
Thus there is always some time series which is
closely correlated with a given time series.

This correlation between two time series can be

of three types. Either the second series dta can
move ahead or move behind or move along
with the first series data.
Accordingly, when the second series moves ahead of
the first series, the second series is known as the
leading series while the first series is called the
lagging series. The opposite holds true when the
second series moves behind the first series. The
series are called coincident series if both of them
move along with each other.

For example, the Bhuj earthquake in January 2001, led

to a massive destruction of property and buildings in
Gujrat. This necessitated construction of building to
rehabilitate the people of the affected areas. The
construction was followed by a spurt in the demand for
cements, fans, tube lights etc. Thus one can say that
the construction of buildings leads to the demand for
cement.
In this case, the construction of building is the
leading indicator or the barometer.

Forecasting techniques that use the lead and lag

relationship between economic variables for
predicting the directional changes in the
concerned variables are known as Barometric
Techniques. These techniques require
ascertaining the lead-lag relationship between
two series and then keeping a track of the
movement of the leading indicator,
 Case : The price elasticity of
demand for edible refined oils
The percentage change in demand of
Sundrop sunflower refined oil produced by
ITC Agrotech Ltd and marketed by ITC ltd.
With percentage change in price and the
change in demand of substitutes was
studied.
The effect of change in Sundrop Suncflower and
subsequent change in demand was studied in
Delhi and three satellite towns viz Ghaziabad,
Gurgaon and Faridabad although Haryana and
UP have a different tax structure than Delhi.

Even as in the market structure Sundrop was

leader in sunflower species , the company
decided to reduce the price range from the
existing Rs.50-55 to Rs.40-45 per litre. The
actual change was brought about in August-
one litre from Rs.51.50 to Rs.44.95

Earlier Dhara Tetra @ Rs.43.50 per litre was

Considered to be the most economical option
available in the market and was perceived as
economy oil
Species wise market structure in Aug
Segment Quantity Demanded (in metric tonnes)
Safflower 250
Groundnut 230
Sunflower 350
Soya 120
Mustard Refined 500
Total 1450
In Aug the market looked like (brandwise)
Brand Name Segment Quantity
Saffola Safflower 250
Dalda Refined Oil Groundnut 80
Postman Groundnut 120
Vital Soya 120
Sweekar Sunflower 50
Dhara Mustard Refined 500
Sundrop Sunflower 180
Total 1450
With the price differential of only Rs.1.45/ ltr and
being the market leader, and also becoming
competitive among other oil segment, the
demand increased due to shift from other
species to sunflower.

Since the brand is the leader and first to reduce

the price, it got major advantage over
competition in terms of shift from other oils

By the year end March next year, the brand

reduced its selling price to Rs.43 and even then
the retailer earned more market.
In additional to the company’s, also had a price
off offer for two months. Hence reducing the
effective price in market.
Brand Name Quantity
Saffola 220
Dalda Refined 120
Post Man 60
Vital 83
Sweekar 87
Flora 35
Dhara 350
Sundrop 250
Total 1205
Determinant of Price Elasticity

1. Availability of Substitute : In the above

example, it is a clear case of substitution
2. Proportion of income spent : The disposable
income of a family is Rs.4000/- and it spends
Rs.1000/- on groceries of which 20 to 25
percent is spent on cooking medium, hence
price plays a major factor in deciding about
the type of oil to be bought. In normal
consumption of four buys five litres of oil per
month.
3. Time Period : Demand is usually more elastic
in the long run than in the short run as we have
seen in case of Sundrop sunflower as by year
end the average that was 250 metric tonnes
shot upto 375 metric tonnes by July next year.

Revenue increase in case of sundrop

Even though, the company reduced its price,

there is an increase in the total revenue earned
by the company.
Before August , the contribution metric/tonnes
was Rs.10,000
Therefore at 180 metric tonnes, the earnings
were 180 x Rs.10,000 = Rs.18,00000.

After reducing the price, the contribution

decreased to Rs.6000/- the earnings increased
due to increase in quantity demanded from 180
to 375 metric tonnes
Rs.6000 x 375 = Rs.22,50,000

From the above case study we find that the

quantity demanded has gone up due to
decrease in price.
Calculate the Price elasticity of demand