MANAGERIAL

ECONOMICS
By SANELISO FUTURE MOYO
economics is the study of mankind’s attempt to satisfy
their unlimited wants with the help of limited resources.
Economics
Can be divided into:
• Micro Economics and
• Macro Economics
• Monitory Economics
• Fiscal Economics.
Economics
• Economics is the science of making decisions in the presence of
scarce resources
• Economic decisions involve the allocation of scarce resources so as to
best meet the managerial goal.
• Micro economics deals with the basic principles of economics like law
of demand, law of supply, consumption, production etc,.
• Managerial economics deals with the principles of micro-economics
as applied to managerial decision making.
Prof. Evan J Douglas defines Managerial Economics as “Managerial
Economics is concerned with the application of economic principles
and methodologies to the decision making process within the firm or
organization under the conditions of uncertainty
The Nature of Managerial Economics
• Managerial economics is concerned with the analysis of finding
optimal solutions to decision making problems of businesses/ firms
(micro economic in nature).
• Managerial economics is a practical subject therefore it is pragmatic.
• Managerial economics describes, what is the observed economic
phenomenon and prescribes what ought to be
The Nature of Managerial Economics
• Managerial economics is based on strong economic concepts.
(conceptual in nature)
• Managerial economics analyses the problems of the firms in the
perspective of the economy as a whole ( macro in nature)
• It helps to find optimal solution to the business problems (problem
solving
What we expect to meet
• Cost analysis
• Production Function
• Demand Analysis
• Advertising
• Pricing Systems
• Resource Allocation
Why study Economics

• It is a study of society and as such is extremely important.

• It trains the mind and enables one to think systematically about the
problems of business and wealth.

• From a study of the subject it is possible to predict economic trends with

some precision.

• It helps one to choose from various economic alternatives

Why study ME
Managerial economics helps in
• Estimating the product demand
• Planning of production schedule
• Deciding the input combinations
• Estimation of cost of production
• Achieving economies of scale and
• Increasing the returns to scale.
Why study ME
• It also includes determining price of the product,
• analyzing market structure to determine the price of the product for
profit maximization, which helps them to control and plan capital in
an effective manner.
Some Key Concepts
The Circular Flow of Economic Activities
The Nature of the Firm
A firm is an association of individuals who have organized themselves for the
purpose of turning inputs into output. The firm organizes the factors of production
to produce goods and services to fulfill the needs of the households. Each firm lays
down its own objectives which is fundamental to the existence of a firm.
Major Objectives of the Firm
• To achieve the Organizational Goal
• To maximize the Output
• To maximize the Sales
• To maximize the Profit of the Organization
• To maximize the Customer and Stakeholders Satisfaction
• To maximize Shareholder’s Return on Investment
• To maximize the Growth of the Organization
Basic Features of the Firm- Assignment
Explain the Pros and Cons of the following business types.
• Sole Trader
• Partnership
• Co-operative
• Private Business Co-operation
• listed Companies
Business Objectives and Models
of the Firm
Neo-Classical Economic Model
Assumptions
• Firms are profit maximisers. Firms will maximise profits where MR=MC
• A firm maximizes profits by creating a gap between revenue and costs.
• In the short run, firms are subject to diminishing returns. In the short run, capital is fixed,
therefore MC is upwardly sloping after diminishing returns sets in.
• Prices are flexible. If there is a shortage of the good, the price mechanism will lead to
higher prices.
• There is an assumption that many markets are competitive and close to the model of
perfect competition, therefore, prices will be determined by competitive pressures.
• Firms employ labour like any other factor of production.
• Neo-classical economics also assumes wages are flexible. For example, if there is a fall in
demand for workers, this will lead to a fall in wages to maintain equilibrium
Neoclassical Theory of the Firm
• In neoclassical economics, the theory of the firm is a microeconomic
concept that states that a firm exists and make decisions to maximize
profits.
• The theory of the firm influences decision-making in a variety of
areas, including resource allocation, production techniques, pricing
adjustments, and the volume of production.
• Modern takes on the theory of the firm sometimes distinguish
between long-run motivations, such as sustainability, and short-run
motivations, such as profit maximization.
Neo-Classical Theory
Where is the maximum profit ?
Criticism of the Neo-Classical Theory
• Firms often seek to maximise the size of the firm and market share, rather than profit.
• Profit satisficing - Firms have a principle-agent problem. The owners may wish to maximise
profits, but the workers don’t. Therefore, the workers do enough to keep the owners happy, but
then pursue other objectives such as enjoying themselves at work. This is also known as a
problem of separation of ownership and control
• Other objectives such as environmental, cultural and social objectives. Humans are not just profit
maximisers but consider other non-financial objectives.
• Wages may not be flexible. For example, unions may resist nominal wage cuts.
• Labour cannot always be treated like a commodity like say capital. This ignores the human
psychology of workers getting frustrated or de-motivated.
• Behavioural economics suggests there is a range of factors that determine business and consumer
behaviour other than utility maximisation theory. Firms may wish to become more prestigious.
They may take risks for non-economic reasons or they may want to avoid losing what they already
have.
The Value of the Neo-Classical Model
• It could be argued that when firms pursue other objectives, they have in the back
of their mind profit maximisation.
• E.g. a firm may engage in a price war to maximise market share. However, the
reason is that in the long run, the firm hopes that this increased market share
enables higher monopoly power and therefore higher profits in the future.
• The same could be said of environmental objectives, these give a better corporate
image and therefore boost long-run profitability
• Profit satisficing can be overcome through share deals and performance-related
pay.
• Therefore the neoclassical theory is useful because it shows how and why firms
should make sure workers have sufficient incentives to maximise profits like the
owners.
Sales Maximisation Model
• Sales maximization model is an alternative model for profit maximization.
• This model is developed by Prof. Boumol, an American economist.
• This alternative goal has assumed greater significance in the context of
the growth of Oligopolistic firms.
• Baumol’s sales revenue maximization model highlights that the primary
objective of a firm is to maximize its sales rather than profit maximization.
• It states that the goal of the firm is maximization of sales revenue subject
to a minimum profit constraint.
• The minimum profit constraint is determined by the expectations of the
share holders. This is because no company can displease the share holders.
Assumptions of the Sales Maximisation
Model
• The firm pursues the objective of sales revenue maximization subject
to minimum profit constraint.
• Price of the product is constant.
• Production costs are independent of advertising.
A Quote from Baumol Himself

“Though businessmen are interested in the scale of their

operations partly because they see some connection between
scale and profits, I think management’s concern with the level
of sales goes considerably further. In my dealings with them I
have been struck with the importance the oligopolistic
enterprises attach to the value of their sales. A small reversal in
an upward sales trend that can quite reasonably be dismissed
as a random movement sometimes leads to a major review of
the concern’s selling and production methods, its product lines,
and even its internal organizational structure.” – Baumol
Sales Maximisation Model
• The basic philosophy is that when sales are maximized automatically
profits of the company would also go up.
• Hence, attention is diverted to increase the sales of the company in
recent years in the context of highly competitive markets.
• Maximizing sales revenue is an alternative to profit maximization and
occurs when the marginal revenue, MR, from selling an extra unit is
zero.
• Sales maximization is an activity that concentrates on revenue
transactions and can be accomplished by employing various sales
strategies and programs.
Sales Maximisation Model
• The thought that maximizing sales will help maximize profits is not always
true.
• An increase in sales is associated with an increase in cost of goods sold and
other expenses.
• Sales maximization programs can be implemented for many reasons and at
various times, but they are not done continuously.
• The start of a business, during lean seasons and at times when there is
excess inventory are examples of those times.
• Sales managers may refrain from maximizing sales without the consent of
general managers to avoid a possible shortage of business resources such
as inventory and manpower.
Rationalisation of the Baumol Model
• There is evidence that salaries and other earnings of top managers are correlated more closely
with sales than with profits.
• The banks and other financial institutions keep a close eye on the sales of firms and are more
willing to finance firms with large and growing sales.
• Personnel problems are handled more satisfactorily when sales are growing. The employees at
all levels can be given higher earnings and better terms of work in general.
• Large sales, growing over time, give prestige to the managers, while large profits go into the
pockets of shareholders.
• Managers, prefer a steady performance with satisfactory profits to spectacular profit
maximization projects. If they realize maximum high profits in one period, they might find
themselves in trouble in other periods when profits are less than maximum.
• Large growing sales strengthen the power to adopt competitive tactics, while a low or declining
share of the market weakens the competitive position of the firm and its bargaining power vis-
à -vis rivals.
Criticism of the Baumol Model
• Unrealistic assumptions
• Interdependence in decision making ignored
• Fails to establish industry equilibrium
• Ignores actual and potential competition
• The price implications of a change in advertising have not been
considered explicitly.
• The empirical validity of the sales revenue maximization objective is
concerned; factual evidence are inconclusive.
• It has also been also argued that, in the long run, sales maximization and
profit maximization objective converge into one.
Sales Maximisation Model
Discussion- discuss the argument
for and against the Baumol Sales
Maximisation theory
Discussion- compare and contrast
the Profit maximization and the
sales maximization models.
Managerial Utility Maximisation model
Managerial utility maximisation theory, developed by American
economist Oliver E Williamson, describes managers’ utility versus profit
maximisation in corporate environment, where management is separated from
owners (shareholders).

According to the theory managers take decisions that prioritise their own utility
maximisation over principals’ profits, provided the firm can generate minimum
profit demanded by the principals to maintain managers’ job security.

The theory describes Managerial Utility (U) as a function of Monetary

Expenditure on Staff (S), Managerial Slack (M) and Discretionary Investment
(Id).
Managerial Utility Maximisation model
• Monetary Expenditure on Staff (S) – manager’s compensation
package as well as spend on his subordinate staff in direct correlation
with their numbers.

Managerial Slack (M) – additional management perks such as expense

accounts, private jets, etc.

Discretionary Investment (Id) – amount of undistributed profit

available for manager’s discretional investment or spending
Managerial Utility Maximisation model
• The theory considers several layers of profit:

Profit(P) is Revenue less Production Costs(C) and Monetary Expenditure on Staff(S)

Minimum Profit (Pmin) is the minimum amount of Profit after Tax required by
Shareholders to keep their stakes in the firm and/or maintain current management
team.

Profit reported (Pr) is Profit (P) less Managerial Slack(M). Should be no less than
Minimum Profit (Pmin) plus Tax in order to maintain manager’s job security

Discretionary Profit(Pd) is Profit(P) less Minimum Profit(Pmin) and Tax. It represents

the amount of Profit at manager’s discretion and can be used to increase Managerial
Utility(U) through Discretionary Investments(Id) and Managerial Slack(M)
Managerial Utility Maximisation model
Managerial Utility Maximisation model
• Firm's profit depends upon Staff Expenditure, provided price and
market remain at equilibrium.

Increase in both Staff Expenditure and Discretionary Profit positively

contributes to Managerial Utility, however increase in Staff
Expenditure will decrease Discretionary Profit. Managers will balance
optimal combination of these factors to maximise levels of their
Utility and maintain at least Minimum Profit levels.

Such equilibrium may be achieved without achieving maximum Profit

for the shareholders.
Managerial Utility Maximisation model
Managerial Utility Maximisation model
• A manager would aim to achieve combination of Staff Expenditure and
Discretionary Profit at the level of utility U1, however in the point of equilibrium
with firms profit (above minimum profit) the level of Staff Expenditure is such that
Discretionary Profit is not at the maximum and therefore shareholders are not
earning all the profit they could if manager’s utility level was lowered through
decreased Staff Expenditure and/or Management Slack.
• Has the manager allocated resources so that his utility would be at lower levels U2
or U3 then Discretionary Profit and therefore overall Profit of the firm would be
higher.
• In other words, once minimum profit has been achieved managers would tend to
allocate firm’s resources towards increasing their own utility rather than
maximising shareholder’s profit.
Marris’ Growth Maximisation Theory
• R. Marris has put forward an important theory of the firm according
to which managers do not maximize profits but instead, according to
him, they seek to maximize balanced rate of growth of the firm.
• Maximization of balanced rate of growth of the firm means
maximization of the rate of growth of demand for the products of the
firm and rate of growth of capital supply
• If G stands for balanced growth, Gd for the growth rate of demand for
the product, GC for the rate of growth of the capital supply, then the
goal of the manager is to maximize G, Thus –
G = Gd = G C
Marris’ Growth Maximisation Theory
• It is usually argued by managerial theorists that the division of ownership and management allows
the managers to set goals which do not necessarily coincide with those of owners.
• The utility function of managers includes variables such as salaries, status, power and job security,
while the utility function of owners includes variables such as profits, size of output, size of
capital, share of the market and public image.
• Thus, managers want to maximize their own utility.
Um = f*(salaries, power, status, job security)
• While the owners seek the maximization of their utility
Uo = f*(profits, capital, output, market share, public esteem).

• Marris argues that the difference between the goals of managers and the goals of the owners is
not so wide as other managerial theories claim, because most of the variables appearing in both
functions are strongly correlated with a single variable – i.e., size of the firm.
Marris’ Growth Maximisation Theory
• However, Marris limits his model to situations of steady rate of
growth over time during which most of the relevant economic
magnitudes change simultaneously, so that ‘maximising the long-run
growth rate of any indicator can reasonably be assumed equivalent to
maximising the long-run rate of most others.’
• Furthermore, Marris argues that the managers do not maximise the
absolute size of the firm (however measured), but the rate of growth
(= change of the size) of the firm.
Marris’ Growth Maximisation Theory
• Marris argues that since growth happens to be compatible with the
interests of the shareholders in general, the goal of maximisation of
the growth rate (however measured) seems a priori plausible.
• There is no need to distinguish between the rate of growth of
demand (which maximises the u of managers) and the rate of growth
of capital supply (which maximises the U of owners) since in
equilibrium these growth rates are equal.
BEHAVIORAL MODELS OF
THE FIRM
Behavioural Theories of the Firm: An examination of the inner motives and
direction of firms, using a range of models and different assumptions about those
who work in a firm.
Introduction
• In classical economics, the theory of firms is based on the assumption
that they will seek profit maximisation. However, in the real world
managers and owners may behave quite differently. Behavioural
Theories of the Firm include:
Size of a firm/prestige.
• Some managers may simply aim for working in a big and seemingly
successful firm which gives more prestige and honour.
• Managers may be motivated to prove their projects are successful.
This can cause firms to pursue goals which have a high profile.
• It may explain why firms persist with projects which may not be
desirable.
• There is a cost to letting go of past decisions.
Profit satisficing.
• Based on the problem of asymmetric information.
• Owners wish to maximise profits, but, workers don’t.
• Because owners don’t have perfect information, workers and
managers are able to get away with decisions that don’t maximise
profits.
Co-operative/ethical concerns.
• Some firms may be set up with very different objectives to the
traditional model of profit maximisation.
• In co-operative firms, the goal is to maximise the welfare of all
stakeholders.
• In this model, ideas of altruism, concern for the environment and
workers welfare may explain many decisions.
• The firm may also be set up with specific charitable aims.
Human emotion/bias.
• The economic model of a rational economic man assumes that
individuals seek to maximise their economic welfare with rational
choice.
• However, in the real world, we are influenced by human emotion. This
could be discrimination based on bias and prejudice.
• Or it could be irrational exuberance and the perceived wisdom of
following the crowd.
• For example, in asset bubbles, mortgage companies can get caught up
in relaxing their lending criteria and lending mortgages to those at risk
of default.
The Behavioural Model of Cyert and
March
• Cyert and March have put forth a systematic behavioural theory of
the firm.
• In a modem large multiproduct firm, ownership is separate from
management.
• Here the firm is not considered as a single entity with a single goal of
profit maximisation by a single decision-maker, called the
entrepreneur.
• Instead, Cyert and March regard the modem business firm as a group
of individuals who are engaged in the decision-making process
relating to its internal structure having multiple goals.
The Behavioural Model of Cyert and March
• They deal not only with the internal organisation of the firm but also
with the problem of uncertainty.
• They reject the assumption of certainty in the neo-classical theory of
the firm.
• They emphasise that the modem busi­ness firm is so complex that
individuals within it have limited information and imperfect foresight
with respect to both internal and external developments.
The Goals of the firm in this model
• Production (output)
• Inventory (output vs sales)
• Sales
• Market share
• Profit
Discussion- What are the
implications of the model on
decision making
Discussion- what are the
criticisms against this model?
II. DEMAND ANALYSIS
The Theory of Consumer
Behavior
Introduction
• Consumer Behaviour is the study of how individual customers, groups
or organizations select, buy, use, and dispose ideas, goods, and
services to satisfy their needs and wants.
• It refers to the actions of the consumers in the marketplace and the
underlying motives for those actions.
What Influences Consumer Behaviour
• i. Marketing factors such as product design, price, promotion,
packaging, positioning and distribution.
• ii. Personal factors such as age, gender, education and income level.
• iii. Psychological factors such as buying motives, perception of the
product and attitudes towards the product.
• iv. Situational factors such as physical surroundings at the time of
purchase, social surroundings and time factor
• v. Social factors such as social status, reference groups and family
• vi. Cultural factors, such as religion, social class—caste and sub-castes.
Nature of Consumer Behaviour
• Influenced by various factors as shown above
• Undergoes constant change
• Varies from consumer to consumer
• Varies among regions and geographies
• Information on CB is important to marketers
• Leads to purchase decision
• Varies from product to product
• Improves standard of living
Introduction
• A buyer demands goods and services from the market and the sellers
supply the goods in the market.
• In economics, demand is “the quantity of goods and services that will
be bought for a given price over a period of time”.
• Demand means the ability and willingness to buy a specific quantity
of a commodity at the prevailing price in a given period of time.
• Therefore, demand for a commodity implies the desire to acquire it,
willingness and the ability to pay for it.
Law of Demand
Law of Demand
• The law of demand is one of the most fundamental concepts in economics.
• It works with the law of supply to explain how market economies allocate
resources and determine the prices of goods and services that we observe
in everyday transactions.
• The law of demand states that quantity purchased varies inversely with
price.
• In other words, the higher the price, the lower the quantity demanded.
This occurs because of diminishing marginal utility.
• That is, consumers use the first units of an economic good they purchase
to serve their most urgent needs first, and use each additional unit of the
good to serve successively lower valued ends.
Law of Demand
• The law of demand is a fundamental principle of economics which states that at
a higher price consumers will demand a lower quantity of a good.
• Demand is derived from the law of diminishing marginal utility, the fact that
consumers use economic goods to satisfy their most urgent needs first.
• A market demand curve expresses the sum of quantity demanded at each price
across all consumers in the market.
• Changes in price can be reflected in movement along a demand curve, but do
not by themselves increase or decrease demand.
• The shape and magnitude of demand shifts in response to changes in consumer
preferences, incomes, or related economic goods, NOT to changes in price.
Law of Demand
• Law of demand: The quantity of a commodity demanded in a given
time period increases as its price falls, ceteris paribus. (i.e. other
things remaining constant)
• Demand schedule: a table showing the quantities of a good that a
consumer is willing and able to buy at the prevailing price in a given
time period.
• Demand Curve: A curve indicating the total quantity of a product that
all consumers are willing and able to purchase at the prevailing price
level, holding the prices of related goods, income and other variables
as constant.
Demand curve
The law of demand
Consumer Equilibrium
• Consumer’s equilibrium is a situation when the consumer spends
their given income on the purchase of one or more commodities in
such a way that they get maximum satisfaction and has no urge to
change this level of consumption, given the prices of commodities.
Definition:
• The state at which a consumer derives maximum utility from the
consumption of one or more goods and services given his/her level of
Income is called Consumer’s Equilibrium. At that level of balance
between total utility and income, the marginal utility of a product is
equal to its one unit price.
Consumer Equilibrium
• Consumers derive utility from each commodity they consume.
• This utility is dependent on the price of a product.
• The point at which the marginal utility (MU) of a product equals its
price (P) is where consumer satisfaction maximizes.
• It is expressed as MU = P .
• If the marginal utility of a product is higher than the price a consumer
would continue to purchase additional units and vice versa until MU
equals the fixed price level.
Importance of Consumer Equilibrium
• It allows a consumer to maximum his/her utility from the
consumption of one or more commodities.
• It helps arrange the combination of two or more products based on
consumer taste and preference for maximum utility.
Consumer Equilibrium
• There are two main approaches to study consumer’s equilibrium. They are as
follows:
• 1. Cardinal utility approach (or Marshall’s utility analysis)
• 2. Ordinal utility approach (or indifference curve analysis)
• Utility: Utility is defined as the power of a commodity to satisfy a human want.
• Utility of a commodity is the total amount of psychological satisfaction that a
person gets from consumption of a good or service, e.g. a thirsty person derives
satisfaction from drinking a glass of water. So a glass of water has got utility for
the thirsty person.
• Utility differs from person to person. Utility is subjective and cannot be
measured quantitatively.
Marginal utility
• Marginal Utility (MU): Marginal utility is the addition to the total
utility derived from the consumption of an additional unit of a
commodity.
• It can also be defined as the utility from the last unit of a commodity
consumed.
• Marginal utility can be calculated by the following formula:
MUn = TUn – TUn–1
Marginal Utility
Where:
• MUn = Marginal utility of nth unit of the commodity
• TUn = Total utility of n units
• TUn–1 = Total utility of n–1 units
• Xn = Quantity of nth unit of good X
• Xn–1 = Quantity or (n–1)th unit of good X
• “n” takes the values 1, 2, 3, ... .
Total Utility
• Total Utility (MU): Total utility is the total satisfaction obtained from
the consumption of all possible units of a commodity.
• Total utility can be obtained by summing up marginal utilities from
consumption of different units of a commodity.
• Thus, total utility can be calculated as: TUn = MU1 + MUZ + MU3
+ ........ MUn
Shift in Demand
• Shift of the demand curve occurs when the determinants of demand
change.
• When tastes and preferences and incomes are altered, the basic
relationship between price and quantity demanded changes (shifts).
• This shifts the entire demand curve upward (rightward) and is called
an increase in demand because more of that commodity is demanded
at that price.
• The downward shift (leftward) is called as decrease in demand.
Shifts in the demand curve
Types of Demand
Direct and indirect demand/Producers’ goods and consumers’ goods
• Demand for goods that are directly used for consumption by the
ultimate consumer is known as direct demand (example: Demand for
T shirts).
• On the other hand demand for goods that are used by producers for
producing goods and services. (example: Demand for cotton by a
textile mill)
Types of demand
Derived demand and autonomous demand:
• When a produce derives its usage from the use of some primary
product it is known as derived demand. (example: demand for tyres
derived from demand for car)
• Autonomous demand is the demand for a product that can be
independently used. (example: demand for a washing machine)
• Durable and non durable goods demand: durable goods are those
that can be used more than once, over a period of time (example:
Microwave oven) Non durable goods can be used only once (example:
Band-aid)
Types of demand
• Firm and industry demand: firm demand is the demand for the
product of a particular firm. (example: Dove soap) The demand for
the product of a particular industry is industry demand (example:
demand for steel in India )
• Short run and long run demand: short run demand refers to demand
with its immediate reaction to price changes and income fluctuations.
• Long run demand is that which will ultimately exist as a result of the
changes in pricing, promotion or product improvement after market
adjustment with sufficient time.
Types of demand
• Market Demand: The total quantity of a good or service that people
are willing and able to buy at prevailing prices in a given time period.
It is the sum of individual demands.
• Cross Demand: The ability and willingness to buy a commodity or
service at the prevailing price of the related commodity i.e.
substitutes or complementary products. For example, people buy
more of wheat when the price of rice increases.
Exceptional Demand curve
Exceptional Demand curve
• The demand curve slopes from left to right upward if despite the
increase in price of the commodity, people tend to buy more due to
reasons like fear of shortages or it may be an absolutely essential
good.
• The law of demand does not apply in every case and situation.
• The circumstances when the law of demand becomes ineffective are
known as exceptions of the law.
• Some of these important exceptions are as under
1. Giffen Goods
• A Giffen good is a low income, non-luxury product that defies
standard economic and consumer demand theory.
• Demand for Giffen goods rises when the price rises and falls when
the price falls.
• The term Giffen good was named after Scottish economist Sir Robert
Giffen.
• The term Giffen good was developed by the economist after he
noticed, in the poor Victorian era, that the rise in the price of a basic
food increased the demand for that particular food.
Giffen Goods
Conditions for a Giffen good
• The good must be inferior as in situations of budget shortage, the
consumer will consume more of the Giffen good.
• It must constitute a substantial portion of the total consumption
relative to the consumer’s budget.
• There must be no close substitute available.
Historical Examples of Giffen Goods
• The cost of bread was rising as people lacked the income to buy meat
during World War II was used as one of the earliest examples by
Alfred Marshall to explain this concept.
• The rice-wheat experiment in China by Harvard economists Jensen
and Miller that went on to show reduction in demand for rice when
the price of rice was reduced through subsidies.
2. Conspicuous Consumption/ Veblen Effect
• A few goods like diamonds are purchased by the rich and wealthy
sections of society.
• The prices of these goods are so high that they are beyond the reach
of the common man.
• The higher the price of the diamond, the higher its prestige value. So
when price of these goods falls, the consumers think that the prestige
value of these goods comes down.
• So quantity demanded of these goods falls with fall in their price.
• So the law of demand does not hold good here
Veblen Effect
3. Conspicuous Necessities
• Certain things become the necessities of modern life. So we have to
purchase them despite their high price.
• The demand for T.V. sets, automobiles and refrigerators etc. has not
gone down in spite of the increase in their price.
• These things have become the symbol of status.
• So they are purchased despite their rising price.
4. Emergencies
• During emergencies like war, famine etc, households behave in an
abnormal way.
• Households accentuate scarcities and induce further price rise by
making increased purchases even at higher prices because of the
apprehension that they may not be available. .
• On the other hand during depression , fall in prices is not a sufficient
condition for consumers to demand more if they are needed
5. Future Changes in Price
• Households also act as speculators.
• When the prices are rising households tend to purchase large
quantities of the commodity out of the apprehension that prices may
still go up.
• When prices are expected to fall further, they wait to buy goods in
future at still lower prices.
• So quantity demanded falls when prices are falling
6. Change in fashion
• A change in fashion and tastes affects the market for a commodity.
• When a digital camera replaces a normal manual camera, no amount
of reduction in the price of the latter is sufficient to clear the stocks.
• Digital cameras on the other hand, will have more customers even
though its price may be going up.
• The law of demand becomes ineffective
7. Snob Effects
• Some buyers have a desire to own unusual or unique products to
show that they are different from others.
• In this situation even when the price rises the demand for the
commodity will be more.
8. Speculative Goods
• Speculative goods such as shares do not follow the law of demand.
• Whenever the prices rise, the traders expect the prices to rise further
so they buy more.
9. Goods in short supply
• Goods that are available in limited quantity or whose future
availability is uncertain also violate the law of demand
ELASTICITY OF DEMAND
Introduction
• In economics, the term elasticity means a proportionate (percentage) change in
one variable relative to a proportionate (percentage) change in another variable.
• The quantity demanded of a good is affected by changes in the price of the good,
changes in price of other goods, changes in income and changes in other factors.
• Elasticity is a measure of just how much of the quantity demanded will be
affected due to a change in price or income.
• Elasticity of Demand is a technical term used by economists to describe the
degree of responsiveness of the demand for a commodity due to a fall in its
price.
• A fall in price leads to an increase in quantity demanded and vice versa.
Price Elasticity
• The responsiveness of changes in quantity demanded due to changes
in price is referred to as price elasticity of demand.
• Price elasticity of demand is a measurement of the change in
consumption of a product in relation to a change in its price.
• The price elasticity of demand is measured by dividing the percentage
change in quantity demanded by the percentage change in price

Price Elasticity of Demand = % Change in Quantity Demanded / %

Change in Price
Income Elasticity
• Income elasticity of demand measures the responsiveness of quantity demanded
to a change in income.
• It is measured by dividing the percentage change in quantity demanded by the
percentage change in income.
• With income elasticity of demand, you can tell if a particular good represents a
necessity or a luxury.
• Demand for a normal good grows with an increase in customer wages and vice
versa, assuming other factors of demand are constant.
• Income elasticity of demand is the level of response in demand to the adjustment
in customer income.
• The larger the income elasticity of demand for a certain product, the greater the
shift in demand there is from a change in consumer income.
Cross Elasticity
• Cross elasticity measures the responsiveness of the quantity
demanded of a commodity due to changes in the price of another
commodity.
• For example the demand for tea increases when the price of coffee
goes up. Here the cross elasticity of demand for tea is high.
• The cross elasticity of demand for substitute goods is always positive
because the demand for one good increases when the price for the
substitute good increases.
Significance of the concept of Demand
Group Work
• There are various kinds of elasticities of demand discussed in this
course.
• Discuss why it is important for managers to have a clear
understanding ofthe elasticity of demand. You should be very clear in
your answer on which elasticity concept you are discussing.
Supply analysis
Introduction
• Supply of a commodity refers to the various quantities of the
commodity which a seller is willing and able to sell at different prices
in a given market at a point of time, other things remaining the same.
• Supply is a fundamental economic concept that describes the total
amount of a specific good or service that is available to consumers.
• Supply can relate to the amount available at a specific price or the
amount available across a range of prices if displayed on a graph
Some concepts
• Supply Schedule: is a table showing how much of a commodity, firms
can sell at different prices.
Law of supply
• The law of supply is the microeconomic law that states that, all other
factors being equal, as the price of a good or service increases, the
quantity of goods or services that suppliers offer will increase, and
vice versa.
• The law of supply says that as the price of an item goes up, suppliers
will attempt to maximize their profits by increasing the quantity
offered for sale.
Supply Curve
• The supply curve is a graphic representation of the correlation
between the cost of a good or service and the quantity supplied for a
given period.
• On most supply curves, as the price of a good increases, the quantity
of supplies increases.
• Supply curves can often show if a commodity will experience a price
increase or decrease based on demand, and vice versa.
• The supply curve is shallower (closer to horizontal) for products with
more elastic supply and steeper (closer to vertical) for products with
less elastic supply.
Supply Curve
• If a factor besides price or quantity changes, a new supply curve
needs to be drawn.
• For example, say that some new soybean farmers enter the market,
clearing forests and increasing the amount of land devoted to
soybean cultivation.
• In this scenario, more soybeans will be produced even if the price
remains the same, meaning that the supply curve itself shifts to the
right (S2) in the graph below.
• In other words, supply will increase.
The Supply Curve
Elasticity of supply
• Elasticity of supply of a commodity is defined as the responsiveness of a
quantity supplied to a unit change in price of that commodity
• The elasticity of supply establishes a quantitative relationship between the
supply of a commodity and it’s price.
• Note that elasticity can also be calculated with respect to the other
determinants of supply.
• However, the major factor controlling the supply of a commodity is its price.
• Therefore, we generally talk about the price elasticity of supply.
• The price elasticity of supply is the ratio of the percentage change in the price
to the percentage change in quantity supplied of a commodity.
Elasticity of supply
• Es= [(Δq/q)×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Where :Δq= The change in quantity supplied

q= The quantity supplied

Δp= The change in price

p= The price
Perfectly Inelastic supply
• A service or commodity has a perfectly inelastic supply if a given
quantity of it can be supplied whatever might be the price.
• The elasticity of supply for such a service or commodity is zero. A
perfectly inelastic supply curve is a straight line parallel to the Y-axis.
• This is representative of the fact that the supply remains the same
irrespective of the price.
• The supply of exclusive items, like the painting of Mona Lisa, falls into
this category.
• Whatever might be the price on offer, there is no way we can
increase its supply.
Relatively less elastic supply
• When the change in supply is relatively less when compared to the
change in price, we say that the commodity has a relatively-less
elastic supply.
• In such a case, the price elasticity of supply assumes a value less than
1.
Relatively greater Elastic supply
• When the change in supply is relatively more when compared to the
change in price, we say that the commodity has a relatively greater-
elastic supply.
• In such a case, the price elasticity of supply assumes a value greater
than 1.
Unitary Elastic
• For a commodity with a unit elasticity of supply, the change in
quantity supplied of a commodity is exactly equal to the change in its
price.
• In other words, the change in both price and supply of the commodity
are proportionately equal to each other.
• To point out, the elasticity of supply in such a case is equal to one.
• Further, a unitary elastic supply curve passes through the origin.
Perfectly Elastic supply
• A commodity with a perfectly elastic supply has an infinite elasticity.
• In such a case the supply becomes zero with even a slight fall in the
price and becomes infinite with a slight rise in price.
• This is indicative of the fact that the suppliers of such a commodity
are willing to supply any quantity of the commodity at a higher price.
• A perfectly elastic supply curve is a straight line parallel to the X-axis.
PRODUCTION ANALYSIS
Introduction
• Production is an important economic activity which satisfies the
wants and needs of the people.
• A firm is an entity that combines and processes resources in order to
produce output that will satisfy the consumer’s needs.
• The firm has to decide as to how much to produce and how much
input factors (labour and capital) to employ to produce efficiently.
• Factors of production include resource inputs used to produce goods
and services. Economist categorise input factors into four major
categories such as land, labour, capital and entrepreneurship.
Land
• This includes any natural resource used to produce goods and services.
• This includes anything that comes from the land.
• Some common land or natural resources are water, oil, copper, natural
gas, coal, and forests.
• Land resources are the raw materials in the production process.
• These resources can be renewable, such as forests, or nonrenewable
such as oil or natural gas.
• The income that resource owners earn in return for land resources is
called rent.
Labour
• Labor is the effort that people contribute to the production of goods
and services.
• Labor resources include the work done by the waiter who brings your
food at a local restaurant as well as the engineer who designed the
bus that transports you to school.
• It includes an artist's creation of a painting as well as the work of the
pilot flying the airplane overhead.
• The income earned by labor resources is called wages and is the
largest source of income for most people.
Capital
• Capital is the machinery, tools and buildings humans use to produce
goods and services.
• Some common examples of capital include hammers, forklifts, conveyer
belts, computers, and delivery vans.
• Capital differs based on the worker and the type of work being done.
• For example, a doctor may use a stethoscope and an examination room
to provide medical services.
• Your teacher may use textbooks, desks, and a whiteboard to produce
education services.
• The income earned by owners of capital resources is interest.
Entrepreneurship
• An entrepreneur is a person who combines the other factors of production - land, labor,
and capital - to earn a profit.
• The most successful entrepreneurs are innovators who find new ways produce goods
and services or who develop new goods and services to bring to market.
• Without the entrepreneur combining land, labor, and capital in new ways, many of the
innovations we see around us would not exist.
• Think of the entrepreneurship of Henry Ford or Bill Gates.
• Entrepreneurs are a vital engine of economic growth helping to build some of the
largest firms in the world as well as some of the small businesses in your neighborhood.
• Entrepreneurs thrive in economies where they have the freedom to start businesses
and buy resources freely.
• The payment to entrepreneurship is profit.
Production Function
• Production function indicates the maximum amount of commodity ‘X’
to be produced from various combinations of input factors.
• It decides on the maximum output to be produced from a given level
of input, and how much minimum input can be used to get the
desired level of output.
• The production function assumes that the state of technology is fixed.
• If there is a change in technology then there would be change in
production function.
The production Function
• The production function describes a boundary or frontier
representing the limit of output obtainable from each feasible
combination of inputs.
• Firms use the production function to determine how much output
they should produce given the price of a good, and what combination
of inputs they should use to produce given the price of capital and
labor.
• The production function also gives information about increasing or
decreasing returns to scale and the marginal products of labor and
capital.
The Production Function
• When firms are deciding how much to produce they typically find that
at high levels of production, their marginal costs begin increasing.
• This is also known as diminishing returns to scale – increasing the
quantity of inputs creates a less-than-proportional increase in the
quantity of output. (long run)
• If it weren’t for diminishing returns to scale, supply could expand
without limits without increasing the price of a good.
The Production Function
• The production manager’s responsibility is that of identifying the right
combination of inputs for the decided quantity of output.
• The major objective of any business organization is maximizing the
output with minimum cost.
• To achieve the maximum output the firm has to utilize the input
factors efficiently.
• In the long run, without increasing the fixed factors it is not possible
to achieve the goal.
• Therefore it is necessary to understand the relationship between the
input and output in any production process in the short and long run.
The Cobb Douglas Production Function
• In 1928, Charles Cobb and Paul Douglas presented the view that
production output is the result of the amount of labor and physical
capital invested.
• This analysis produced a calculation that is still in use today, largely
because of its accuracy.
• The Cobb-Douglas production function reflects the relationships
between its inputs - namely physical capital and labor - and the
amount of output produced.
• It's a means for calculating the impact of changes in the inputs, the
relevant efficiencies, and the yields of a production activity.
The Cobb Douglas Production Function
The Cobb Douglas Production Function
• In this formula, Q is the quantity produced from the inputs L and K.
• L is the amount of labor expended, which is typically expressed in hours.
• K represents the amount of physical capital input, such as the number of hours for a particular
machine, operation, or perhaps factory.
• A, which appears as a lower case b in some versions of this formula, represents the total factor
productivity (TFP) that measures the change in output that isn't the result of the inputs.
• Typically, this change in TFP is the result of an improvement in efficiency or technology. The Greek
characters alpha and beta reflect the output elasticity of the inputs.
• Output elasticity is the change in the output that results from a change in either labor or physical
capital.
• For example, if the output elasticity for physical capital (K) is 0.60 and K is increased by 20 percent,
then output increases by 3 percent (0.6/0.2). The same is true for the output elasticity of labor: an
increase of 10 percent in L with an output elasticity of 0.40 increases the output by 4 percent
(0.4/0.1).
Marginal Product
• Another concept associated with the Cobb-Douglas production
function is marginal product, which is the change in the output that
results from one additional unit of a single production factor with all
other factors held constant.
• Or, as the economists say, ceteris parabis, which means 'all other
things equal.'
• Marginal product is measured in physical units, which is why it is also
called marginal physical product.
Marginal Product
• For example, consider a company called WeeBee Toys.
• When there are no workers in the factory, there is no output even though
physical capital is present.
• When a single worker shows up, three units are produced per labor hour.
When two workers come in, output increases to five units per hour.
• The addition of the labor of the second worker results in two more units per
hour, or a marginal product of two.
• Because the marginal product is directly related to the increase in labor, this is
also called the marginal product of labor.
• Had the increase in output been a result of new technology or physical
capital, the change would be marginal product of capital.
Short-Run Production Function
• In the short run, some inputs (land, capital) are fixed in quantity.
• The output depends on how much of other variable inputs are used.
• For example if we change the variable input namely (labour) the production
function shows how much output changes when more labour is used.
• In the short run producers are faced with the problem that some input factors
are fixed.
• The firms can make the workers work for longer hours and also can buy more raw
materials.
• In that case, labour and raw material are considered as variable input factors. But
the number of machines and the size of the building are fixed.
• Therefore it has its own constraints in producing more goods.
Long Run production Function
• In the long run all input factors are variable.
• The producer can appoint more workers, purchase more machines
and use more raw materials.
• Initially output per worker will increase up to an extent. This is known
as the Law of Diminishing Returns or the Law of Variable Proportion.
• To understand the law of diminishing returns it is essential to know
the basic concepts of production
Law of Diminishing returns
• Also called principle of diminishing marginal productivity,
• The law of diminishing marginal returns is a theory in economics that
predicts that after some optimal level of capacity is reached, adding
an additional factor of production will actually result in smaller
increases in output.
• For example, a factory employs workers to manufacture its products,
and, at some point, the company operates at an optimal level.
• With all other production factors constant, adding additional workers
beyond this optimal level will result in less efficient operations.
Law of diminishing returns
Isoquant Curves
• An isoquant curve is a concave-shaped line on a graph that charts all the
factors, or inputs, that produce a specified level of output.
• This graph is used as a metric for the influence that the inputs—most
commonly, capital and labor—have on the obtainable level of output or
production.
• The isoquant curve assists companies and businesses in making
adjustments to inputs to maximize production, and thus profits.
• The isoquant curve demonstrates the principle of the marginal rate of
technical substitution, which shows the rate at which you can substitute
one input for another, without changing the level of resulting output.
Iso-quant Curves
• It may also be called an iso-product curve.
• Most typically, an isoquant shows combinations of capital and labor,
and the technological tradeoff between the two—how much capital
would be required to replace a unit of labor at a certain production
point to generate the same output.
• Labor is often placed along the X-axis of the isoquant graph, and
capital along the Y-axis.
Assumptions of the Iso-Quant curves
Two Factors of Production:
• Only two factors are used to produce a commodity.
Divisible Factor:
• Factors of production can be divided into small parts.
Constant Technique:
• Technique of production is constant or is known before hand.
Possibility of Technical Substitution:
• The substitution between the two factors is technically possible. That is, production
function is of ‘variable proportion’ type rather than fixed proportion.
Efficient Combinations:
• Under the given technique, factors of production can be used with maximum efficiency.
Iso-Quant Curve
Managerial Uses of the Production Function
• It may be used to compute the least-cost combination of inputs for a
given output.
• It may be used by the manager to obtain the most appropriate
combination of input. Which yields the maximum level of output with
a given level of cost.
• Helps the managers in deciding the additional value of variable input
employed in the production process.
• Production functions help the managers in taking long-run decisions.
As with increasing returns to scale the production may be increased
through a proportionate increase in. the factors of production.
Managerial uses of the Production Function
• The production function can thus answer a variety of questions. It
can, for example, measure the marginal productivity of a particular
factor of production (i.e., the change in output from one additional
unit of that factor).
• It can also be used to determine the cheapest combination of
productive factors that can be used to produce a given output.
• To find the most profitable rate of operation of the firm.
• To determine the optimum quantity of output to be produced and
supplied.
Market Structures
Market structure, in economics, refers to how different industries are
classified and differentiated based on their degree and nature of
competition for goods and services.
It is based on the characteristics that influence the behavior and
outcomes of companies working in a specific market.
Market Structures
Features that distinguish Market Structures
• The industry’s buyer structure
• The turnover of customers
• The extent of product differentiation
• The nature of costs of inputs
• The number of players in the market
• Vertical integration extent in the same industry
• The largest player’s market share
Features that distinguish Market Structures
• By cross-examining the above features against each other, similar
traits can be established.
• Therefore, it becomes easier to categorize and differentiate
companies across related industries.
• Based on the above features, economists have used this information
to describe four distinct types of market structures.
• They include perfect competition, oligopoly market, monopoly
market, and monopolistic competition.