UNIT 1

Managerial Economics
The Basic Decision-Making Units
 A firm is an organization that transforms resources (inputs) into
products (outputs). Firms are the primary producing units in a
market economy.
 An entrepreneur is a person who organizes, manages, and assumes
the risks of a firm, taking a new idea or a new product and turning it
into a successful business.
 Households are the consuming units in an economy.
CONCEPT OF DEMAND
Concept of Demand
 Demand in economics means desire to buy backed by adequate purchasing
power and willingness to buy the product.
 Demand refers to the various quantities of a commodity that a consumer is
buy during a given period of time at different prices.
 We can say that at price of Rs. 5 the demand is 80 units.
Shift of Demand Versus Movement Along a
Demand Curve

• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
A Change in Demand Versus a Change in Quantity
Demanded

• When demand shifts to

the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
A Change in Demand Versus a Change in Quantity
Demanded

To summarize:

Change in price of a good or service

leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
 The Impact of a Change in the Price of
Related Goods
• Demand for complement good
(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
Why does Demand curve slope downwards

The following points highlight the seven main reasons for the downward sloping
demand curve.
1. LAW OF DIMINISHING MARGINAL UTILITY: The law of demand is based on the law of
Diminishing Marginal Utility. According to this law, when a consumer buys more units of a
commodity, the marginal utility of that commodity continues to decline. Therefore, the consumer
will buy more units of that commodity only when its price falls.
When less units are available, utility will be high and the consumer will be prepared to pay more for
the commodity. This proves that the demand will be more at a lower price and it will be less at a
higher price. That is why the demand curve is downward sloping.

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

3. INCOME EFFECT: When the price of a commodity falls, the real income of the
consumer increases because he has to spend less in order to buy the same quantity.
On the contrary, with the rise in the price of the commodity, the real income of the
consumer falls.
This is called the income effect. Under the influence of this effect, with the fall in
the price of the commodity the consumer buys more of it and also spends a portion
of the increased income in buying other commodities.

4. SUBSTITUTION EFFECT: The other effect of change of the price of the commodity is the
substitution effect. With the fall in the price of a commodity, the prices of its substitutes
remaining the same, consumers will buy more of this commodity rather than the
substitutes.
As a result, its demand will increase. On the contrary, with the rise in the price of the
commodity (under consideration) its demand will fall, given the prices of the substitutes.
For instance, with the fall in the price of tea, the price of coffee being unchanged, the
demand for tea will rise, and contrariwise, with the increase in the price of tea, its demand
will fall.
Why does Demand curve slope
downwards

5. DIFFERENT USES OF COMMODITY: There are different uses of certain

commodities and services that are responsible for the negative slope of the
demand curve. With the increase in the price of such products, they will be used
only for more important uses and their demand will fall. On the contrary, with the
fall in price, they will be put to various uses and their demand will rise.

6. INCREASE IN THE NUMBER OF CONSUMERS

Supply in Output Markets

SUPPLY SCHEDULE
• A supply schedule is a table
FOR SOYBEANS showing how much of a product
firms will supply at different
QUANTITY
SUPPLIED (
prices.
PRICE KGS PER
(PER KGS) YEAR) • Quantity supplied represents the
2 0
1.75 10 number of units of a product that
2.25 20 a firm would be willing and able to
3.00 30
4.00 45 offer for sale at a particular price
5.00 45
during a given time period.
The Supply Curve and
the Supply Schedule
• A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.
6

Price of soybeans per bushel ($)

5
4
3
2
1
0
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
The Law of Supply

6
 The law of supply states that
Price of soybeans per bushel ($) there is a positive relationship
5 between price and quantity of
4 a good supplied.
3  This means that supply curves
typically have a positive slope.
2
1
0
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
Determinants of Supply
 The price of the good or service.
 The cost of producing the good, which in turn depends on:
 The price of required inputs (labor,
capital, and land),
 The technologies that can be used to
produce the product,
 The prices of related products.
Market Equilibrium
 The operation of the market
depends on the interaction between
buyers and sellers.
 An equilibrium is the condition that
exists when quantity supplied and
quantity demanded are equal.
 At equilibrium, there is no tendency
for the market price to change.
Market Equilibrium
 Only in equilibrium is quantity
supplied equal to quantity
demanded.

• At any price level

other than P0, the
wishes of buyers
and sellers do not
coincide.
ELASTICITY OF DEMAND
 Determinants of
Price Elasticity of Demand

Demand tends to be more elastic :

 if the good is a luxury.
 the longer the time period.
 the larger the number of close substitutes.
 the more narrowly defined the market.
Consumer’s Equilibrium-Marshallian and Hicksian Approach
Consumer’s equilibrium-Single commodity case

 Consumer’s equilibrium in case of a single commodity can be explained on the

basis of the law of diminishing marginal utility.
 How does a consumer decide as to how much to buy of a good? It will depend
upon two factors.
 (a) The price he pays for each unit which is given and
 (b) The utility he gets
 At the time of purchasing a unit of a commodity, a consumer compares the
price of the given commodity with its utility. The consumer will be at
equilibrium when marginal utility (in terms of money) equals the price paid for
the commodity say ‘X’ i.e. MUx = PX. If MUX > Px, the consumer goes on buying
the commodity because he is paying less for each additional amount of
satisfaction. As he buys more, MU falls due to operation of law of diminishing
marginal utility. When MU becomes equal to price, consumer gets maximum
satisfaction and now she is at equilibrium
CONSUMER’S EQUILIBRIUM IN CASE OF TWO OR MORE
COMMODITIES

 The law of diminishing marginal utility applies in case of one commodity only. But in
real life a consumer normally consumes more than one commodity. In such a
situation, law of equi-marginal utility helps in optimum allocation of his income.
Law of equi-marginal utility is based on law of diminishing marginal utility.
 According to the law of equi-marginal utility a consumer will be in equilibrium when
the ratio of marginal utility of a commodity to its price equals the ratio of marginal
utility of other commodity to its price
ORDINAL UTILITY APPROACH (INDIFFERENCE CURVE ANALYSIS)
 You have already studied the utility approach which was based on the
assumption that utility is measurable numerically (like 1 util, 2 utils, 3 utils).
This is called cardinal utility approach. Prof. J.R. Hicks criticized the utility
approach as unrealistic because satisfaction (utility) is a subjective
phenomenon and so it can never be measured precisely. He, therefore,
presented an alternative technique known as indifference curve approach
(also called ordinal utility approach). It is based on the assumption that every
consumer has a scale of preference in the form of assigning ranks (like 1st
2nd, 3rd rank) to different combinations of two goods called bundle and can
tell which bundle he likes most.
Indifference curves
 An indifference curve is a line showing all the combinations of two goods which give a
consumer equal utility. In other words, the consumer would be indifferent to these
different combinations.
Indifference Map

We can also show different

indifference curves.
All choices on I2 give the
same utility. But, it will be
a higher net utility than
indifference curve I1.
Properties of Indifference Curves

1. They Slope Negatively or Slope Downwards from the Left to the Right:
 This is an important feature of Indifference Curve. If the total satisfaction is to remain
the same, the consumer must part with a diminishing number of one item as he gets as
increasing stock of another item. The loss of satisfaction to the consumer on account of
the downward movement must be made up by the gain through the rightward
movement. As such the Indifference Curve must slope downwards to the right.
2. They are Convex to the Origin of Axes:
 The second property of the Indifference Curve is that they are generally convex to the
origin of the axes. This property of the Indifference Curve is derived from the Law of
Diminishing Marginal Rate of Substitution. If the marginal rate of substitution had
increased, the Indifference Curve would have been concave to the origin. If the
marginal rate of substitu­tion had remained constant, the Indifference Curve would
have been a diagonal straight line at 45° angle.
3. Every Indifference Curve to the right represents Higher Level of Satisfaction than
that of the Proceeding One:
Let us take two Indifference Curves IC1 and IC2 lying to the right of IC1. At the point P the
consumer gets OM of oranges and ON of bananas. At the point Q though the number of bananas
remains the same i.e., ON, yet the number of oranges increases from OM to OM 1. The total
satisfaction of the consumer is therefore bound to be greater at Q than at P. Hence Q represents a
more valued and preferred combination of oranges and bananas than P. As all the points on one
Indifference Curve represents equal satisfac­tion, therefore every point on IC2 represents a
combination, preferred to that represented by any point on IC. An Indifference Curve to the right
represents a preferred position and therefore a consumer will always try to move on the
indifference map as much to the right as possible.
Indifference Curves can neither touch nor Intersect each other, so that one
Indifference Curve Passes through only one Point on an Indifference Map:

Since point A is an Indifference Curve IC2, it represents a higher level of

satisfaction to the consumer c than point B which is located on the lower
Indifference c Curve IC1. Point C, however lies on both the curves. This m means
that two levels of satisfaction, A and B which are by definition unequal manage to
become equal at the point C. This is clearly impossible. Indifference Curve can
never intersect each other: