Business Economics

Unit 1
Introduction to Economics
• Economics is the social science that analyzes
the production, distribution, and
consumption of goods and services.
Factors of Production
• LAND-RENT
• LABOUR-WAGES
• CAPITAL-INTEREST
• ENTREPRENEURSHIP- PROFIT
Origin
• The term economics comes from the Ancient Greek (oikonomia,
"management of a household, administration") from (oikos, "house") +
(nomos, "custom" or "law"), hence "rules of the house (hold)".
Introduction
• Economics studies the process by which limited resources are
allocated to satisfy infinite human wants, that is how different
societies allocate scarce resources optimally to satisfy the wants and
needs of their members.
• Economics mainly deals with making choices about production,
distribution and consumption of goods and services (commodities) to
satisfy present and future needs of the society.
• Economics also deals with money-how it is created, and how its
supply is regulated.
Economics : Definitions
• Adam Smith (1776) : Wealth
• Alfred Marshall (1890) : Welfare
• Lionel Robbins (1935) : Scarcity and Choice
• Paul Samuelson (1948) : Growth
• Economics is the study of production, distribution and consumption of
goods and services for members of a society by the optimal use of limited
resources to satisfy the unlimited wants of individuals.
• Economics thought as given by
• Adam Smith – Economics is focused on Wealth
• Alfred Marshall- Economics is concerned with Welfare
• Lionel Robbins – Economics is concerned with decision making with
regard to making BEST choices with respect to scarcity of resources.
• Paul Samuelson- Economics studies the Growth of an Economy or its
stakeholders
• Difference between Need, Wants and Demand
• Factors of Production-Land, Labour, Capital and Entrepreneurship
Managerial Economics(Business Economics)
• Managerial Economics may be viewed as the study of economic
principles and methods which are relevant or useful for managerial
decision making of firms.
• The role of managerial economist:-A managerial economist helps the
management by using his analytical skills and highly developed in
solving complex issues of successful decision-making and future
advanced planning.
• Edwin Mansfield "Managerial or Business economics is concerned with
the ways in which managers should make decisions in order to maximize
the effectiveness or performance of the organizations they manage”
• Prof.Douglas”Business 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”

Business Economics refers to the application of economic theory and

the tools of analysis of decision sciences to find the optimal solution to
managerial or decisional problems.
• Business economics bridges economic theory and economics in
practice.
• Business economics tries to find out whatever is likely to be the best
for the firm under a given set of conditions.
Differences between Economics and Business
Economics
Area of Difference Economics Business Economics
Nature Economics deals with the body of It deals with application of
the principles itself. economic principles to the problems
of business firms
Nature of Economic Principles Economics deals with both micro It basically deals with the application
Studied and macro-economic principles- of normative micro-economic
normative as well as positive. principles and involves value
judgements.It is concerned with
what decisions ought to be made.

Scope of Study Micro economics as a multi-facet Though business economics is micro

branch of Economics. It deals not in character, it deals with the
only with the economic problems of problems of the business firms.
business firms, but also individual’s
economic problems.Thus,Economics
has a wider scope of study.
Focus of study Under micro-economics as a branch
of economics, distribution theories
like rent, wage and interest are dealt
along with the theory of profit.
Approach to Study Economic theory takes assumptions,
hypothesis-economic relationships
and generates economic model
models.
Methodology Economic theory avoids many
complexities and makes simplified
assumptions to solve complicated
theoretical issues
The main focus of study of business
economics is profit theory. Other
distribution theories have not much
relevance here.
Business economics adopts,
modifies or reformulates already
existing economic models to suit the
specific conditions and serves the
specific problems of the business
firm.
Business economics is pragmatic in
the sense that it introduces some
realistic aspects such as objectives of
the firm, resource, legal and
behavioral constraints,
environmental and technological
factors,etc and attempts to solve
some real life complex business
problems using other related
branches like mathematics, statistics,
economics, operations
research,accounting,etc.
Scope of Business Economics

Fundamentals of Business Economics

• Basic concepts and principles of economics
• Opportunity cost and production possibility curve
• Scarcity and efficiency
Scope of Business Economics
The Consumer Markets

• Demand and Supply Analysis

• Demand function
• Demand schedule and demand curve
• Determinants of demand
• Demand forecasting
• Supply function
• Supply schedule and supply curve
• Equilibrium of supply and demand curve
• Price Elasticity of demand
• Elasticity and revenue
The Business Organization

• Prediction of consumer behavior

• Determination of demand curve, like price, income, taste, prices of
other brands, etc
• How and when consumers react to market signals like price
• Consumer preferences and business organization
• Determinants of firms behavior
• Input cost, output and profit relations
• Price determination in different market structures
• Pricing and sales strategies of firms
Role of a managerial economist
• A managerial economist helps the management by using his analytical
skills and highly developed techniques in solving complex issues of
successful decision-making and future advanced planning.
• The role of managerial economist can be summarized as follows:
• He studies the economic patterns at macro-level and analyses it’s
significance to the specific firm he is working in.
• He has to consistently examine the probabilities of transforming an
ever-changing economic environment into profitable business
avenues.
• He assists the business planning process of a firm.
• He also carries cost-benefit analysis.
• He assists the management in the decisions pertaining to internal
functioning of a firm such as changes in price, investment plans, type of
goods /services to be produced, inputs to be used, techniques of
production to be employed, expansion/ contraction of firm, allocation of
capital, location of new plants, quantity of output to be produced,
replacement of plant equipment, sales forecasting, inventory forecasting,
etc.
• In addition, a managerial economist has to analyze changes in macro-
economic indicators such as national income, population, business
cycles, and their possible effect on the firm’s functioning.
• He is also involved in advising the management on public relations,
foreign exchange, and trade. He guides the firm on the likely impact of
changes in monetary and fiscal policy on the firm’s functioning.
• He also makes an economic analysis of the firms in competition. He
has to collect economic data and examine all crucial information about
the environment in which the firm operates.
• The most significant function of a managerial economist is to conduct
a detailed research on industrial market.
• In order to perform all these roles, a managerial economist has to
conduct an elaborate statistical analysis.
• He must be vigilant and must have ability to cope up with the
pressures.
• He also provides management with economic information such as tax
rates, competitor’s price and product, etc. They give their valuable
advice to government authorities as well.
• At times, a managerial economist has to prepare speeches for top
management.
 Application Areas
1.Risk analysis - various models are used to quantify risk and
asymmetric information and to employ them in decision rules of
manage risk.
2.Production analysis - microeconomic techniques are used to analyze
production efficiency, optimum factor allocation costs, and to estimate
the firm's cost function.
3.Pricing analysis - microeconomic techniques are used to analyze various
pricing decision including transfer pricing join product pricing price
description price elasticity estimations, and choosing the optimum pricing
method.
4.Capital budgeting - Investment theory is used to examine a firm's
capital purchasing decision
Micro and Macro Economics
• MICRO ECONOMICS:-
1.Evolution of micro economics took place earlier than macro
economics.
2.It is branch of economics, which studies individual economic
variables like demand, supply, price etc.
3.It has a very narrow scope i.e. an individual, a market etc.
4.Demand,supply,market forms etc. relate to micro economics.
5.It is helpful in analysis of an individual economics unit like firm.
6.Theory of demand, theory of production, price determination theory
etc. develop from micro economics.
• MACRO ECONOMICS:-
1.It evolved only after the publication of Keynes‘ Book, General theory
of employment, interest and money.(1936)
2.It is a branch of economics which studies aggregate economic
variables, like aggregate demand, aggregate supply, price level etc.
3.It has a very wide scope i.e. a country.
4.Aggregate demand aggregate supply, national income etc. relate to
macro economics.
5.It is helpful for analyzing the level of employment, income, economic
growth etc.
6.Theory of national income, theory of employment, theory of money,
theory of general price level etc. develop from macro economics.
Opportunity Cost(OC)
• Opportunity cost is cost of the next best alternative foregone.
• the loss of other alternatives when one alternative is chosen.
• When an option is chosen from alternatives, the opportunity cost is the
"cost" incurred by not enjoying the benefit associated with the best
alternative choice.
• the loss of potential gain from other alternatives when one alternative
is chosen.
• OC=Kind of a SACRIFICE
•Opportunity Cost=Cost of the Lost
Opportunity
Why Opportunity Cost is Important?
• The fundamental problem of economics is the issue of scarcity.
Therefore we are concerned with the optimal use and distribution of
these scarce resources. Wherever there is scarcity we are forced to
make choices.
• For Example-If we have Rs.400, we can spend it on an economic
textbook, or we can enjoy a meal in a restaurant. Therefore, many
choices involve an opportunity cost – having to make choices between
the two.
• Key Relationship between SCARCITY & CHOICE
• "the basic relationship between scarcity and choice".
• The notion of opportunity cost plays a crucial part in attempts to
ensure that scarce resources are used efficiently.
• Opportunity costs are not restricted to monetary or financial costs:
the real cost of output forgone, lost time, pleasure or any other benefit
that provides utility should also be considered an opportunity cost. The
opportunity cost of a product or service is the revenue that could be
earned by its alternative use.
• Even Environmental Cost-Air Pollution is also a cost.
• Social Cost=Not able to spend time with your family if you are busy
HISTORY
• The term was first used in 1894 by David L. Green in an article in
the Quarterly Journal of Economics entitled "Pain Cost and
Opportunity-Cost. The idea had been anticipated by previous writers
including Benjamin Franklin and Frédéric Bastiat. Franklin coined the
phrase “Time is Money”
• Bastiat's 1848 essay "What Is Seen and What Is Not Seen" used
opportunity cost reasoning in his critique of the broken window
fallacy, and of what he saw as spurious arguments for public
expenditure.
Examples of opportunity cost
• The cost of war. If the government spends Rs.10,000 Crores on a war, it is
Rs.10,000 Crores they cannot spend on education, health care or cutting taxes /
reducing the budget deficit.
• Spending on new roads. If the government build a new road, then that money
can’t be used for alternative spending plans, such as education and healthcare.
• Tax cuts. If the government offers an income tax cut, the opportunity cost is that
government revenue cannot be used to finance some aspect of government
spending.
• Time. If you have 12 hours at your disposal during the day, you could spend these
hours in work or leisure. The opportunity cost of spending all day watching TV is
that you are not able to do any study during the day.
• Enter the workforce at 16. If you enter the workforce at 16 without
qualifications you start earning money straight away. But the opportunity cost is
that you lose out on the potential of getting better qualifications and possibly a
higher salary in the long-run.
Opportunity cost and a free good

• If there is no opportunity cost in consuming a good, we can term it a

free good.
• For example, if you breathe air, it doesn’t reduce the amount available
to other people – there is no opportunity cost.
Application of OC=Cost of Capital
• For an investment to be worthwhile, the expected return on capital has
to be higher than the cost of capital. Given a number of competing
investment opportunities, investors are expected to put their capital to
work in order to maximize the return.
• In other words, the cost of capital is the rate of return that capital could
be expected to earn in the best alternative investment of equivalent
risk; this is the opportunity cost of capital.
• EXAMPLE-AIRTEL investment into Zain Telecom, South Africa
Time Value of Money(TVM)
• The time value of money means your 1000 Rupees today is worth
more than your 1000 Rupees tomorrow because of inflation.
• Inflation increases prices over time and decreases your money’s
purchasing power.
• 1000 Rupees will buy more in the present time than it will in the
future.
• This is why investing is so important.
Present Value
• The answer, $85.73, tells us that receiving $100 in two years is the
same as receiving $85.73 today, if the time value of money is 8% per
year compounded annually.
Future Value
• PV=1000 Rs.
• r=10%
• n= 3 years

• FV=1000(1+0.01)^3
• FV=1,331 Rs.
Application of TVM(PV,FV)
• The time value of money is a major financial consideration for
companies. Essentially, you compare the value of money in hand
versus the relative value of money you receive or pay out in the future.
Inflation, risk factors, potential investment returns and loan interest
impact business decisions.
 Decisions

• Typically, businesses make time value decisions that compare near-

term and long-term earning or borrowing potential. If you sell goods
on credit, you must consider the lost opportunity to earn interest on the
money if you were paid cash.
• If you receive payment in six months and charge a 2-percent penalty,
you probably could have earned more than 2 percent on investments
with the cash up front.
• Similarly, if you owe $1,000 on a loan at 5 percent, you might
compare the interest saved on paying the balance versus investment
opportunities gained by delaying payment.
Marginalism
• Marginalism is the study of additional use gained from surplus
increases in the number of goods created, sold, etc. and how they
relate to demand and consumer choice.
• Change in Quantity=1,UNIT wise
• The idea of marginalism and its use in establishing market prices, as
well as supply and demand patterns, was popularized by
British economist Alfred Marshall in a publication dating back to
1890.
Examples of Marginalism

• One of the key foundations of marginalism is the concept of marginal

utility. The utility of a product or service is its usefulness in satisfying
our needs. Marginal utility extends the concept to the additional
satisfaction derived from the same product or service.
• Within the context of consumption, there is the law of diminishing
marginal utility, which states that consumption is inversely
proportional marginal utility. This means that as consumption
increases, the marginal utility derived from a product or service
declines. Thus, the satisfaction that a consumer derives from a new
product is highest when he or she is first introduced to it. Subsequent
use of the product or service diminishes the satisfaction derived from it.
Total Utility and Marginal Utility
Marginal Revenue
Marginal Cost
Incrementalism
• Increase in the quantity, revenue or sales but which cannot be
measured easily.

• Bulk Change but small gradual change.

Examples

• In the 1970s, many countries decided to invest in wind energy. Denmark,

a small country of around 5 million people, became a world leader in this
technology using an incremental approach. While more formal design
processes in the US, Germany and the United Kingdom failed to develop
competitive machines. The reason for the difference of approach was
that the Danish wind industry developed from an agricultural base whilst
the American and UK wind industries were based on hi-
tech aerospace companies with significant university involvement. While
the Danes built better and better windmills using an incremental
approach, those using formal planning techniques believed that they
could easily design a superior windmill straight away.
• In practice, however, windmill design is not very complicated and the
biggest problem is the tradeoff between cost and reliability. Although
the UK and the U.S.A. designs were technically superior, the lack of
experience in the field meant that their machines were less reliable in
the field. In contrast, the heavy agricultural windmills produced by the
Danes just kept turning, and by 2000 the top three windmill
manufacturers in the world were Danish.
Illustration:

• Some businessmen hold the view that to make an overall profit, they must make a
profit on every job. The result is that they refuse orders that do not cover full costs
plus a provision of profit. This will lead to rejection of an order which prevents
short run profit. A simple problem will illustrate this point. Suppose a new order is
estimated to bring in an additional revenue of Rs. 10,000. The costs are estimated
as under:
• Labour Rs. 3,000
• Materials Rs. 4,000
• Overhead charges Rs. 3,600
• Selling and administrative expenses Rs. 1,400
• Full Cost Rs.12, 000
• The order appears to be unprofitable. For it results in a loss of Rs.
2,000. However, suppose there is idle capacity which can be utilised to
execute this order. If order adds only Rs. 1,000 to overhead charges,
and Rs. 2000 by way of labour cost because some of the idle workers
already on the pay roll will be deployed without added pay and no extra
selling and administrative costs, then the actual incremental cost is as
follows:
• Labour Rs. 2,000
• Materials’ Rs. 4,000
• Overhead charges Rs. 1,000
• Total Incremental Cost Rs. 7,000
• Thus there is a profit of Rs. 3,000. The order can be accepted on the
basis of incremental reasoning. Incremental reasoning does not mean
that the firm should accept all orders at prices which cover merely
their incremental costs.
Example of Lenskart
• Online Sales through the website-MAJOR Sales
• Offline Sales-through their retail outlets-Incremental Sales
Another Example
• In the case of climate change the opinions changed gradually over the
years as more and more scientific evidence became clear to policy
makers that it should be a prevalent policy issue. Political economy of
climate change and Politics of global warming are worth noting on the
international scale of climate change policy and how there has been an
incremental leaning towards the belief and action against climate
change over the years.
Forces of Demand

• Demand is the quantity of a good that consumers are willing and able to
purchase at various prices during a given period of time. The relationship
between price and quantity demanded is also known as the demand curve.
• Quantity demanded (Qd) is the amount that a consumer is willing to buy
at a particular price at a particular time.
• In another words, demand is the quantity demanded at all prices during a
specific time period. A change in price will change the quantity
demanded, not the demand. Any other factors other than price change
will change the demand. Non-price factors include taste and preference,
income, price of related goods, future expectation, number of buyers, etc.
Forces of Supply

• Supply (S) is a schedule, which shows amounts of a product a producer is

willing and able to produce and sell at each specific price in a series of
possible prices during a specified time period.
• Quantity supplied (Qs) is the amount of a product that producers
are willing and able to produce and sell at a particular price at a particular
time.
• In another words, supply is the quantity supplied at all prices during a
specific time period. A change in price will change the quantity
supplied, not the supply. Any other factors other than price change
will change the supply. Non-price factors include wage, price of related
resources, cost of production, tax, expectation, number of sellers, etc.
Market Equilibrium
• When the supply and demand curves intersect, the market is in
equilibrium.
• This is where the quantity demanded and quantity supplied are equal.
• The corresponding price is the equilibrium price or market-clearing
price, the quantity is the equilibrium quantity.
• Putting the supply and demand curves from the previous sections
together. These two curves will intersect at Price = Rs.6, and Quantity
= 20. In this market, the equilibrium price is Rs.6 per unit, and
equilibrium quantity is 20 units.
• At this price level, market is in equilibrium. Quantity supplied is equal
to quantity demanded ( Qs = Qd).
• Market is clear.
Surplus and shortage:

• If the market price is above the equilibrium price, quantity supplied is

greater than quantity demanded, creating a surplus. Market price will
fall.
• Example: if you are the producer, you have a lot of excess inventory that
cannot sell. Will you put them on sale? It is most likely yes. Once you
lower the price of your product, your product’s quantity demanded will
rise until equilibrium is reached. Therefore, surplus drives price down.
• If the market price is below the equilibrium price, quantity supplied is
less than quantity demanded, creating a shortage. The market is not
clear. It is in shortage. Market price will rise because of this shortage.
• Example: if you are the producer, your product is always out of stock.
Will you raise the price to make more profit? Most for-profit firms will
say yes. Once you raise the price of your product, your product’s
quantity demanded will drop until equilibrium is reached. Therefore,
shortage drives price up.
• If a surplus exist, price must fall in order to entice additional quantity
demanded and reduce quantity supplied until the surplus is
eliminated. If a shortage exists, price must rise in order to entice
additional supply and reduce quantity demanded until the shortage is
eliminated.
Shortage and Surplus
If the market price (P) is higher than Rs.6 (where Qd = Qs),
for example, P=8, Qs=30, and Qd=10.
Since Qs>Qd, there are excess quantity supplied in the
market, the market is not clear. Market is in surplus.

THE PRICE WILL DROP BECAUSE OF THIS SURPLUS.

If the market price is lower than equilibrium price, Rs.6,
for example, P=4, Qs=10, and Qd=30.
Since Qs<Qd, There is excess quantity demanded in the
market. Market is not clear. Market is in shortage.

THE PRICE WILL RISE DUE TO THIS SHORTAGE.

Price Ceiling and Price Floors
• Government regulations will create surpluses and shortages in the
market. When a price ceiling is set, there will be a shortage. When
there is a price floor, there will be a surplus.
• Price Floor: is legally imposed minimum price on the market.
Transactions below this price are prohibited.
•Policy makers set floor price above the market equilibrium price which
they believed is too low.
•Price floors are most often placed on markets for goods that are an
important source of income for the sellers, such as labor market.
•Price floor generate surpluses on the market. •Example: minimum
wage.
• Price Ceiling: is legally imposed maximum price on the market.
Transactions above this price is prohibited. •Policy makers set ceiling
price below the market equilibrium price which they believed is too high.
• Intention of price ceiling is keeping stuff affordable for poor people.
•Price ceiling generates shortages on the market. •Example: Rent control.
Nudge Theory
• Nudge theory is a concept in behavioral economics, political
theory, and behavioral sciences that proposes positive
reinforcement and indirect suggestions as ways to influence the
behavior and decision-making of groups or individuals.
• The nudge concept was popularized in the 2008 book Nudge: Improving
Decisions About Health, Wealth, and Happiness, by behavioral
economist Richard Thaler and legal scholar Cass Sunstein, two American
scholars at the University of Chicago.
Richard Thaler Cass Sunstein
• The Nudge Theory is a flexible and modern concept in
behavioral sciences to understand how people think,
make decisions, and behave. The concept helps people
to improve their thinking and decisions, manage all
kinds of changes, and identify and change existing
influences.
• The ‘Nudge Theory’ recognizes this behavioral trait. It
says that people, rather than being forced, can be
encouraged and influenced to pursue or desist from
certain actions through nudges.
• Public policy examples of ‘Nudge’ at work include
automatic enrolment of employees into pension
schemes in the UK and the opt-out system for organ
donation in Spain. By making the optimal choice the
default option for all citizens, these nudges have
helped improve public participation in these
programmes.
• Nudges are not mandates. So, while there is
encouragement, there is no compulsion to comply
and people have the freedom to choose other
options.
• Example: Tax breaks under different sections of
Income tax filing encourages the tax payers to invest
more in financial instruments to save tax.
• By offering insights into how humans think and act,
the Nudge Theory can be used to drive favourable
behaviour and avoid unfavourable ones, without
resorting to drastic interventions such as penal action
or outright bans.
• For instance, the not-so-effective SC ban on sale of
firecrackers this Diwali season in Delhi could have
been avoided had people been ‘nudged’ well in
advance into realizing the adverse effect on air
quality and public health due to widespread
firecracker usage.
• The Government’s Swachh Bharat drive could also
benefit from nudging people into understanding the
ill-effects of unclean surroundings.
Different Types of Nudges
• Perception Nudge: Target the underlying perceptions of
organizational behavior to bring about a change in understanding, and
therefore, a change in behavior.
An example – we react differently to the same information depending
on how it is framed and our choices are often affected by whether the
outcomes are framed in terms of the gains or losses. For example, food
described as 99% fat free is perceived as more favorable than food
described as 1% fat.
• Motivation Nudge: These are needed when you
want employees to care about a change. One way of
doing this is to reference other people’s behaviors to
highlight what is acceptable and desirable.
An example – Electricity companies use information
collected from smart meters to tell their customers how
their energy usage compares to their neighbors. Telling
people that they use more energy than their neighbors
has been found to motivate people to reduce their
usage.
• Ability & Simplicity Nudge: This is needed when
colleagues feel that it is too much effort to carry out a
desired behavior. It is important to enable people to
change and make changes simple. The easier it is, the
more likely people will carry it out.
An example – we can be deterred from taking action by
seemingly small barriers. HMRC (UK govt.) improved
tax collection rates by making it easier for people to pay.
Rather than sending people to a web page that contained
the form they needed to complete, they sent them
directly to the form. Doing this increased response rates
from 19% to 23%.
 Some Examples of Nudge Theory

• The American Grocery store Pay & Save placed green

arrows on the floor leading to the fruit and veg aisles.
They found shoppers followed the arrows 9 times out
of 10 and their sales of fresh produce skyrocketed.
• When eating out you will often see one item which is
much more expensive than anything else on the menu.
The restaurant does not expect you to buy that item,
they expect you to buy the second most expensive.
When you compare the relative prices, the second
most expensive item can seem like a bargain.
• When you buy a burger, you’re likely to purchase fries and soft drinks
when they’re offered as a suggestion
• When there is an additional cost for plastic bags at stores, you’re less
likely to purchase one, thereby reducing plastic consumption
• Schools often hang posters or pictures of inspirational leaders and
their quotes to encourage students to think in a particular way