MODULE 1

COURSE LEARNING OUTCOME

EXPLAIN THE MANAGERIAL ECONOMICS CONCEPTS AND

PRINCIPLES.

TOPIC LEARNING OUTCOMES

At the end of the course, you will be able to:

• Discuss the meaning, objectives, importance, functions, responsibilities and characteristic of managerial
economics.
• Construct demand schedule and demand curve.
• Compute the price elasticity of demand.
• Compare and contrast the different types of market structure.

LECTURE NOTES (INPUT)

CHAPTER 1 - INTRODUCTION TO ECONOMICS

1.1 ECONOMICS AND MANAGERIAL ECONOMICS CONCEPTS

The term “economics” has been derived from a Greek Word “Oikonomia” which means “household‟.
Economics is a social science. It is called “social‟ because it studies mankind of society. It deals with aspects of human
behavior. It is called science since it studies social problems from a scientific point of view. The development of
economics as a growing science can be traced back in the writings of Greek philosophers like Plato and Aristotle.
Economics was treated as a branch of politics during early days of its development because ancient Greeks applied this
term to management of city- state, which they called “Polis”.

Definition of Economics

A. Wealth Definition

Really the science of economics was born in 1776, when Adam Smith published his famous book “An Enquiry into the
Nature and Cause of Wealth of Nation”. He defined economics as the study of the nature and cause of national wealth.
According to him, economics is the study of wealth- How wealth is produced and distributed. He is called as “father of
economics” and his definition is popularly called “Wealth definition”.

B. Welfare Definition

It was Alfred Marshall who rescued the economics from the above criticisms. By his classic work “Principles of
Economics”, published in 1890, he shifted the emphasis from wealth to human welfare. According to him wealth is
simply a means to an end in all activities, the end being human welfare. He adds, that economics “is on the one side a
study of the wealth; and the other and more important side, a part of the study of man”. Marshall gave primary importance
to man and secondary importance to wealth.

C. Scarcity Definition

Lionel Robbins formulated his own conception of economics in his book “The Nature and Significance of Economic
Science” in 1932. According to him, “Economics is the science which studies human behavior as a relationship between
ends and scares means which have alternative uses”. He gave importance to four fundamental characters of human
existence such as;

1. Unlimited wants- In his definition “ends” refers to human wants which are boundless or unlimited.
2. Scarcity of means (Limited Resources) – the resources (time and money) at the disposal of a person to satisfy his wants
are limited.
3. Alternate uses of Scares means- Economic resources not only scarce but have alternate uses also. So one has to make
choice of uses.
4. The Economic Problem –when wants are unlimited, means are scarce and have alternate uses, the economic problem
arises. Hence we need to arrange wants in the order of urgency.

D. Modern Definition

The credit for revolutionizing the study of economics surely goes to Lord J.M Keynes. He defined economics as the
“study of the administration of scares resources and the determinants of income and employment”.

Prof. Samuelson recently given a definition based on growth aspects which is known as Growth definition. “Economics is
the study of how people and society end up choosing, with or without the use of money to employ scarce productive
resources that could have alternative uses to produce various commodities and distribute them for consumption, now or in
the future, among various persons or groups in society. Economics analyses the costs and the benefits of improving
patterns of resources use”.

Simple Definition

Economics is the science of making decisions in the presence of scarce resources.

Meaning and Definition of Managerial Economics.

Managerial Economics shows how economic analysis can be used in formulating policies. Managerial economics bridges
the gap between traditional economic theory and real business practices in two ways. Firstly, it provides number of tools
and techniques to enable the manager to become more competent to take decisions in real and practical situation.
Secondly, it serves as an integrating course to show the interaction between various areas in which the firm operates.

Managerial economics is concerned with the application of business principles and methodologies to the decision
making process within the firm or organization under the conditions of uncertainty. It seeks to establish rules and
principles to facilitate the attainment of the desired economic aim of management. These economic aims relate to costs,
revenue and profits and are important within both business and non business institutions.
Managerial Economics as “the integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning of management” managerial economics helps the managers to analyze the
problems faced by the business unit and to take vital decisions. They have to choose from among a number of possible
alternatives. They have to choose that course of action by which the available resources are most efficiently used.

Managerial economics is some thing that concerned with business efficiency”.

Managerial Economics is the study of how to direct scares resources in a way that mostly effectively achieves a
managerial goal”.

Objectives and Uses (importance) of managerial Economics

Objectives:

The basic objective of managerial economics is to analyze the economic problems faced by the business. The other
objectives are:

1. To integrate economic theory with business practice.

2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm.
5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion implementation of policies etc...

1.2 Objectives and Uses (importance) of managerial Economics

Objectives: The basic objective of managerial economics is to analyze the economic problems faced by the business. The
other objectives are:

1. To integrate economic theory with business practice.

2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm.
5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion implementation of policies etc...
Importance: In order to solve the problems of decision making, data are to be collected and analyzed in the light of
business objectives. Managerial economics provides help in this area. The importance of managerial economics maybe
relies in the following points:

1. It provides tool and techniques for managerial decision making.

2. It gives answers to the basic problems of business management.
3. It supplies data for analysis and forecasting.
4. It provides tools for demand forecasting and profit planning.
5. It guides the managerial economist.
6. It helps in formulating business policies.
7. It assists the management to know internal and external factors influence the business.

Following are the important areas of decision making;

a) Selection of product.
b) Selection of suitable product mix.
c) Selection of method of production.
d) Product line decision.
e) Determination of price and quantity.
f) Decision on promotional strategy.
g) Optimum input combination.
h) Allocation of resources.
i) Replacement decision.
j) Make or buy decision.
k) Shut down decision.
l) Decision on export and import.
m) Location decision.
n) Capital budgeting.

Scope of Managerial / Business Economics

The scope of managerial economics refers to its area of study. Scope of Managerial Economics is wider than the scope of
Business Economics in the sense that while managerial economics dealing the decisional problems of both business and
non-business organizations, business economics deals only the problems of business organizations. Business economics
giving solution to the problems of a business unit or profit oriented unit. Managerial economics giving solution to the
problems of non-profit organizations like schools, hospital etc. The scope covers two areas of decision making (A)
operational or internal issues and (B) Environmental or external issues.

A) Operational/internal issues

These issues are those which arise within the business organization and are under the control of the management. They
pertains to simple questions of what to produce, when to produce, how much to produce and for which category of
consumers. The following aspects may be said to be fall under internal issues.

1. Demand analysis and Forecasting: - The demands for the firms product would change in response to change in price,
consumer‟s income, his taste etc. which are the determinants of demand. A study of the determinants of demand is
necessary for forecasting future demand of the product.
2. Cost analysis: - Estimation of cost is an essential part of managerial problems. The factors causing variation of cost
must be found out and allowed for it management to arrive at cost estimates. This will helps for more effective planning
and sound pricing practices.
3. Pricing Decisions: - The firms aim to profit which depends upon the correctness of pricing decisions. The pricing is an
important area of managerial economics. Theories regarding price fixation helps the firm to solve the price fixation
problems.
4. Profit Analysis: - Business firms working for profit and it is an important measure of success. But firms working under
conditions of uncertainty. Profit planning become necessary under the conditions of uncertainty.
5. Capital budgeting: - The business managers have to take very important decisions relating to the firms capital
investment. The manager has to calculate correctly the profitability of investment and to properly allocate the capital.
Success of the firm depends upon the proper analysis of capital project and selecting the best one.
6. Production and supply analysis: - Production analysis is narrower in scope than cost analysis. Production analysis is
proceeds in physical terms while cost analysis proceeds in monitory term. Important aspects of supply analysis are; supply
schedule, curves and functions, law of supply, elasticity of supply and factors influencing supply.

B) Environmental or external issues

It refers to the general business environment in which the firm operates. A study of economic environment should include:

1. The types of economic system in the country.

2. The general trend in production, employment, income, prices, savings and investments
3. Trends in the working of financial institutions like banks, financial corporations, insurance companies etc..
4. Magnitude and trends in foreign trade.
5. Trends in labor and capital market.
6. Government economic policies viz., industrial policy, monitory policies, fiscal policy, price policy etc…
2.3 FUNCTIONS AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST

A managerial economist can play an important role by assisting the management to solve the difficult problems of
decision making and forward planning. Managerial economists have to study external and internal factors influencing the
business while taking the decisions. The important questions to be answered by the managerial economists include:

1. Is competition likely to increase or decrease?

2. What are the population shifts and their influence in purchasing power?
3. Will the price of raw materials increase or decrease?
4. Managerial economist can also help the management in taking decisions regarding internal operation of the firm.

Following are the important specific functions of managerial economist;

1. Sales forecasting. 2. Market research.

3. Production scheduling 4. Economic analysis of competing industry.
5. Investment appraisal. 6. Security management analysis.
7. Advise on foreign exchange management. 8. Advice on trade.
9. Environmental forecasting. 10. Economic analysis of agriculture Sales forecasting

The responsibilities of managerial economists are the following;

1. To bring reasonable profit to the company.
2. To make accurate forecast.
3. To establish and maintain contact with individual and data sources.
4. To keep the management informed of all the possible economic trends.
5. To prepare speeches for business executives.
6. To participate in public debates
7. To earn full status in the business team.

Chief Characteristics of Managerial or Business economics.

Following are the important feature of managerial economics:

1) Managerial economics is Micro economic in character. Because it studies the problems of a business firm, not the
entire economy.
2) Managerial economics largely uses the body of economic concepts and principles which is known as “Theory of the
Firm” or “Economics of the firm”.
3) Managerial economics is pragmatic. It is purely practical oriented. So Managerial economics considers the particular
environment of a firm or business for decision making.
4) Managerial economics is Normative rather than positive economics (descriptive economics). Managerial economics is
prescriptive to solve particular business problem by giving importance to firms aim and objectives.
5) Macroeconomics is also useful to managerial economics since it provides intelligent understanding of the environment
in which the business is operating.
6) It is management oriented.

Managerial economics as a tool for decision making and forward planning.

Decision making: Decision making is an integral part of modern management. Perhaps the most important function of the
business manager is decision making. Decision making is the process of selecting one action from two or more alternative
course of actions. Resources such as land, labour and capital are limited and can be employed in alternative uses, so the
question of choice is arises.

Managers of business organizations are constantly faced with wide variety of decisions in the areas of pricing, product
selection, cost control, asset management and plant expansion. Manager has to choose best among the alternatives by
which available resources are most efficiently used for achieving the desired aims. Decision making process involves the
following elements;

1. The identification of the firm‟s objectives.

2. The statement of the problem to be solved.
3. The listing of various alternatives.
4. Evaluation and analysis of alternatives.
5. The selection best alternative
6. The implementation and monitoring of the alternative which is chosen.

Forward Planning: -Future is uncertain. A firm is operating under the conditions of risk and uncertainty. Risk and
uncertainty can be minimized only by making accurate forecast and forward planning. Managerial economics helps
manager in forward planning which means making plans for the future. A manager has to make plan for the future e.g.
Expansion of existing plants etc...The study of macro economics provides managers a clear understanding about
environment in which the business firm is working. The knowledge of various economic theories viz, demands theory,
supply theory etc. also can be helpful for future planning of demand and supply. So managerial economics enables the
manager to make plan for the future.
Microeconomics VS Macroeconomics

Microeconomics the branch of economics that focuses on actions of particular agents within the economy, like
households, workers, and business firms.

Macroeconomics the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and
trade balance.

Economics VS Managerial economics.

Economics Managerial Economics

1. Dealing both micro and macro aspects 1. Dealing only micro aspects

2. Both positive and normative science. 2. Only a normative science.

3. Deals with theoretical aspects 3. Deals with practical aspects.

4. Study both the firm and individual. 4. Study the problems of firm only.

5. Wide scope 5. Narrow scope.

CHAPTER 2 – DEMAND CONCEPTS

2.2 Meaning of Demand

Demand is a common parlance means desire for an object. But in economics demand is something more than this. In
economics „Demand‟ means the quantity of goods and services which a person can purchase with a requisite amount of
money. According to Prof.Hidbon, “Demand means the various quantities of goods that would be purchased per time
period at different prices in a given market. Thus demand for a commodity is its quantity which consumer is able and
willing to buy at various prices during a given period of time. Simply, demand is the behavior of potential buyers in a
market.

“Demand in economics means demand backed up by enough money to pay for the goods demanded”. In other words,
demand means the desire backed by the willingness to buy a commodity and purchasing power to pay. Hence desire alone
is not enough. There must have necessary purchasing power, ie, .cash to purchase it. For example, everyone desires to
posses Benz car but only few have the ability to buy it. So everybody cannot be said to have a demand for the car. Thus
the demand has three essentials-Desire, Purchasing power and Willingness to purchase.

Demand Analysis Demand analysis means an attempt to determine the factors affecting the demand of a commodity or
service and to measure such factors and their influences. The demand analysis includes the study of law of demand,
demand schedule, demand curve and demand forecasting. Main objectives of demand analysis are;

1) To determine the factors affecting the demand.

2) To measure the elasticity of demand.
3) To forecast the demand.
4) To increase the demand.
5) To allocate the recourses efficiently

Law of Demand The law of Demand is known as the „first law in market”. Law of demand shows the relation between
price and quantity demanded of a commodity in the market. In the words of Marshall “the amount demanded increases
with a fall in price and diminishes with a rise in price”.

According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at higher prices”.
In other words while other things remaining the same an increase in the price of a commodity will decreases the quantity
demanded of that commodity and decrease in the price will increase the demand of that commodity. So the relationship
described by the law of demand is an inverse or negative relationship because the variables (price and demand) move in
opposite direction. It shows the cause and effect relationship between price and quantity demand.

NOTE: Demand is the willingness to buy a commodity and ability to buy it.

Individual demand Schedule

An individual demand schedule is a list of quantities of a commodity purchased by an individual consumer at different
prices. The following table shows the demand schedule of an individual consumer for apple.

When the price falls from P10 to P8, the quantity demanded increases from one to two. In the same way as price falls,
quantity demanded increases. On the basis of the above demand schedule we can draw the demand curve as follows;
 PRICE OF APPLE
QUANTITY DEMANDED
(IN PESO)
10 1
8 2
6 3
4 4
2 5

The demand curve shows the inverse relation between price and demand of apple. Due to this inverse relationship,
demand curve is slopes downward from left to right. This kind of slope is also called “negative slope”.

Market demand schedule

Market demand refers to the total demand for a commodity by all the consumers. It is the aggregate quantity demanded
for a commodity by all the consumers in a market. It can be expressed in the following schedule.

FIGURE 2.1
PRICE PER DOZEN DEMAND BY CONSUMER
MARKET DEMAND
(IN PESOS) A B C D
10 1 2 0 0 3
8 2 3 1 0 6
6 3 4 2 1 10
4 4 5 3 2 14
2 5 6 4 3 18
Derivation of market demand curve is a simple process. For example, let us assume that there are four consumers in a
market demanding eggs. When the price of one dozen eggs is P10, A buys one dozen and B buys 2 dozens. When price
falls to P8, A buys 2 , B buys 3 and C buys one dozen. When price falls to P6, A buys 3 b buys 4,C buys 2 and D buys one
dozen and so on. By adding up the quantity demanded by all the four consumers at various prices we get the market
demand curve. So last column of the above demand schedule gives the total demand for eggs at different prices.

Assumptions of Law of Demand

Law of demand is based on certain basic assumptions. They are as follows

1) There is no change in consumers’‟ taste and preference

2) Income should remain constant.
3) Prices of other goods should not change.
4) There should be no substitute for the commodity.
5) The commodity should not confer any distinction.
6) The demand for the commodity should be continuous.
7) People should not expect any change in the price of the commodity.

Why does demand curve slopes downward?

1) Law of Diminishing Marginal utility

As the consumer buys more and more of the commodity, the marginal utility of the additional units falls. Therefore the
consumer is willing to pay only lower prices for additional units. If the price is higher, he will restrict its consumption.
2) Income effect.
When the price of the commodity falls, the real income of the consumer will increase. He will spend this increased
income either to buy additional quantity of the same commodity or other commodity.

3) Substitution effect.
When the price of tea falls, it becomes cheaper. Therefore the consumer will substitute this commodity for coffee. This
leads to an increase in demand for tea.

4) Different uses of a commodity.

Some commodities have several uses. If the price of the commodity is high, its use will be restricted only for important
purpose. For e.g. when the price of tomato is high, it will be used only for cooking purpose. When it is cheaper, it will be
used for preparing jam, pickle etc...

5) Psychology of people.
Psychologically people buy more of a commodity when its price falls. In other word it can be termed as price effect.

Exceptions to the Law of Demand. (Exceptional Demand Curve).

The basic feature of demand curve is negative sloping. But there are some exceptions to this. I.e... In certain
circumstances demand curve may slope upward from left to right (positive slopes). These phenomena may due to;

1) Giffen paradox.
The Giffen goods are inferior goods is an exception to the law of demand. When the price of inferior good falls, the poor
will buy less and vice versa. When the price of maize falls, the poor will not buy it more but they are willing to spend
more on superior goods than on maize. Thus fall in price will result into reduction in quantity. This paradox is first
explained by Sir Robert Giffen.

2) Veblen or Demonstration effect.

According to Veblen, rich people buy certain goods because of its social distinction or prestige. Diamonds and other
luxurious article are purchased by rich people due to its high prestige value. Hence higher the price of these articles,
higher will be the demand.

3) Ignorance
Some times consumers think that the product is superior or quality is high if the price of that product is high. As such they
buy more at high price.

4) Speculative Effect
When the price of commodity is increasing, then the consumer buy more of it because of the fear that it will increase still
further.

5) Fear of Shortage
During the time of emergency or war, people may expect shortage of commodity and buy more at higher price to keep
stock for future.

6) Necessaries
In the case of necessaries like rice, vegetables etc., People buy more even at a higher price.

7) Brand Loyalty
When consumer is brand loyal to particular product or psychological attachment to particular product, they will continue
to buy such products even at a higher price.

8) Festival, Marriage etc.

In certain occasions like festivals, marriage etc. people will buy more even at high price.

When price raises from OP to OP1 quantity demanded also increases from OQ to OQ1. In other words, from the above,
we can see that there is positive relation between price and demand. Hence, demand curve (DD) slopes upward.
CHANGES IN DEMAND (SHIFTERS OF DEMAND)

Demand of a commodity may change. It may increase or decrease due to changes in certain factors. These factors are
called determinants of demand. These factors include;

1) Price of a commodity
2) Nature of commodity
3) Income and wealth of consumer
4) Taste and preferences of consumer
5) Price of related goods (substitutes and compliment goods)
6) Consumers‟ expectations.
7) Advertisement

Note: Demand and price are inversely related.

Note: Income and Demand are Directly related.

a.) If substitutes of a particular commodity are available in the market and the price of the substitute rises,
demand for the commodity rises.

Substitute Demand

Substitute Demand

b.) If complements are available

Complements Demand

Note: If expectation of future prices is high, then more demand is there at present and vice versa.

Note: Other than above mentioned determinants, quantity demanded is also dependant upon population, composition of
population, geographical conditions etc.

Demand Function.

There is a functional relationship between demand and its various determinants. I.e., a change in any determinant will
affect the demand. When this relationship expressed mathematically, it is called Demand Function. Demand function of a
commodity can be written as follows:

D = f (P, Y, T, Ps, U)

Where, D= Quantity demanded P= Price of the commodity

Y= Income of the consumer T= Taste and preference of consumers.
Ps = Price of substitutes U= Consumers expectations & others
f = Function of (indicates how variables are related)

Extension and Contraction of Demand.

Demand may change due to various factors. The change in demand due to change in price only, where other factors
remaining constant, it is called extension and contraction of demand. A change in demand solely due to change in price is
called extension and contraction. When the quantity demanded of a commodity rises due to a fall in price, it is called
extension of demand. On the other hand, when the quantity demanded falls due to a rise in price, it is called contraction of
demand. It can be understand from the following diagram.
When the price of commodity is OP, quantity demanded is OQ. If the price falls to P2, quantity demanded increases to
OQ2. When price rises to P1, demand decreases from OQ to OQ1. In demand curve, the area a to c is extension of
demand and the area a to b is contraction of demand. As result of change in price of a commodity, the consumer moves
along the same demand curve.

Shift in Demand (Increase or Decrease in demand)

When the demand changes due to changes in other factors, like taste and preferences, income, price of related goods etc...
, it is called shift in demand. Due to changes in other factors, if the consumers buy more goods, it is called increase in
demand or upward shift or shift to the right. On the other hand, if the consumers buy fewer goods due to change in other
factors, it is called downward shift or decrease in demand or shift to the left. The increase and decrease in demand
(upward shift and downward shift) can be expressed by the following diagram.

D is the original demand curve. Demand curve shift upward due to change in income, taste & preferences etc of
consumer, where price remaining the same. In the above diagram demand curve D1- D1 is showing upward shift or
increase in demand and D2-D2 shows downward shift or decrease in demand.

2.2 ELASTICITY OF DEMAND

Meaning of Elasticity

Law of demand explains the directions of changes in demand. A fall in price leads to an increase in quantity demanded
and vice versa. But it does not tell us the rate at which demand changes to change in price. The concept of elasticity of
demand was introduced by Marshall. This concept explains the relationship between a change in price and consequent
change in quantity demanded. Nutshell, it shows the rate at which changes in demand take place.

Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to a change in price”. Thus it
represents the rate of change in quantity demanded due to a change in price. There are mainly two types of elasticity of
demand:
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand

Price Elasticity of Demand Price Elasticity of demand measures the change in quantity demanded to a change in price. It
is the ratio of percentage change in quantity demanded to a percentage change in price. This can be measured by the
following formula.

PRICE ELASTICITY = Proportionate Change in Quantity Demanded

Proportionate Change in Price

OR

PRICE ELASTICITY (Q2-Q1)/Q1

=
(P2-P1)/P1

Where: Q1 = Quantity demanded before price change

Q2 = Quantity demanded after price change
P1 = Price charged before price change
P2 = Price charge after price change.

5 TYPES OF ELASTICITY OF DEMAND

There are five types of price elasticity of demand. (Degree of elasticity of demand) Such as perfectly elastic demand,
perfectly inelastic demand, relatively elastic demand, relatively inelastic demand and unitary elastic demand.

1) Perfectly elastic demand (infinitely elastic)

When a small change in price leads to infinite change in quantity demanded, it is called perfectly elastic demand. In this
case the demand curve is a horizontal straight line as given below. (Here ep= ∞)

2) Perfectly inelastic demand

In this case, even a large change in price fails to bring about a change in quantity demanded. I.e. the change in price will
not affect the quantity demanded and quantity remains the same whatever the change in price. Here demand curve will be
vertical line as follows and ep= 0

3) Relatively elastic demand

Here a small change in price leads to very big change in quantity demanded. In this case demand curve will be fatter one
and ep=>1

4) Relatively inelastic demand

Here quantity demanded changes less than proportionate to changes in price. A large change in price leads to small
change in demand. In this case demand curve will be steeper and ep=<1

5) Unit elasticity of demand ( unitary elastic)

Here the change in demand is exactly equal to the change in price. When both are equal, ep= 1, the elasticity is said to be
unitary.

The above five types of elasticity can be summarized as follows:

INCOME ELASTICITY

Income Elasticity is a measure of responsiveness of potential buyers to change in income. It shows how the quantity
demanded will change when the income of the purchaser changes, the price of the commodity remaining the same. It
may be defined thus: The Income Elasticity of demand for a good is the ratio of the percentage change in the amount
spent on the commodity to a percentage change in the consumer’s income, price of commodity remaining constant.
Thus,

Income Elasticity = Proportionate change in the quantity purchased

Proportionate change in Income

Income elasticity of demand mainly of three types:

1) Zero income Elasticity.

2) Negative income Elasticity
3) Positive income Elasticity

Zero income elasticity – In this case, quantity demanded remain the same, eventhogh money income increases.ie,
changes in the income doesn‟t influence the quantity demanded (Eg.salt,sugar etc). Here Ey (income elasticity) = 0

Negative income elasticity -In this case, when income increases, quantity demanded falls.Eg, inferior goods. Here Ey = <
0.

Positive income Elasticity - In this case, an increase in income may lad to an increase in the quantity demanded. i.e.,
when income rises, demand also rises. (Ey =>0) This can be further classified in to three types:

a) Unit income elasticity; Demand changes in same proportion to change in income.i.e, Ey = 1

b) Income elasticity greater than unity: An increase in income brings about a more than proportionate increase in
quantity demanded.i.e, Ey =>1
c) Income elasticity less than unity: when income increases quantity demanded is also increases but less than
proportionately. I.e., Ey =<1

Business decision based on income elasticity.

The concept of income elasticity can be utilized for the purpose of taking vital business decision. A businessman can rely
on the following facts.

If income elasticity is greater than Zero, but less than one, sales of the product will increase but slower than the general
economic growth.
 If income elasticity is greater than one, sales of his product will increase more rapidly than the general economic growth.

Firms whose demand functions have high income elasticity have good growth opportunities in an expanding economy.
This concept helps manager to take correct decision during business cycle and also helps in forecasting the effect of
changes in income on demand.

Cross Elasticity of Demand

Cross elasticity of demand is the proportionate change in the quantity demanded of a commodity in response to change in
the price of another related commodity. Related commodity may either substitutes or complements. Examples of
substitute commodities are tea and coffee. Examples of compliment commodities are car and petrol. Cross elasticity of
demand can be calculated by the following formula;

Cross Elasticity = Proportionate Change in Quantity Demanded of a Commodity

Proportionate Change in the Price of Related Commodity

If the cross elasticity is positive, the commodities are said to be substitutes and if cross elasticity is negative, the
commodities are compliments. The substitute goods (tea and Coffee) have positive cross elasticity because the increase in
the price of tea may increase the demand of the coffee and the consumer may shift from the consumption of tea to coffee.

Complementary goods (car and petrol) have negative cross elasticity because increase in the price of car will reduce the
quantity demanded of petrol.

The concept of cross elasticity assists the manager in the process of decision making. For fixing the price of product
which having close substitutes or compliments, cross elasticity is very useful.

Importance of Elasticity.

The concept of elasticity of demand is much of practical importance;

1. Production- Producers generally decide their production level on the basis of demand for their product. Hence
elasticity of demand helps to fix the level of output.
2. Price fixation- Each seller under monopoly and imperfect competition has to take into account the elasticity of demand
while fixing their price. If the demand for the product is inelastic, he can fix a higher price.
3. Distribution- Elasticity helps in the determination of rewards for factors of production. For example, if the demand for
labour is inelastic, trade union can raise wages.
4. International trade- This concept helps in finding out the terms of trade between two countries. Terms of trade means
rate at which domestic commodities is exchanged for foreign commodities.
5. Public finance- This assists the government in formulating tax policies. In order to impose tax on a commodity, the
government should take into consideration the demand elasticity.
6. Nationalization- Elasticity of demand helps the government to decide about nationalization of industries.
7. Price discrimination- A manufacture can fix a higher price for the product which have inelastic demand and lower
price for product which have elastic demand.

Determinants of elasticity.

Elasticity of demand varies from product to product, time to time and market to market. This is due to influence of various
factors. They are;

1. Nature of commodity- Demand for necessary goods (salt, rice,etc,) is inelastic. Demand for comfort and luxury good
are elastic.
2. Availability/range of substitutes – A commodity against which lot of substitutes are available, the demand for that is
elastic. But the goods which have no substitutes, demand is inelastic.
3. Extent /variety of uses- a commodity having a variety of uses has a comparatively elastic demand.Eg.Demand for steel,
electricity etc..
4. Postponement/urgency of demand- if the consumption of a commodity can be post pond, then it will have elastic
demand. Urgent commodity has inelastic demand.
5. Income level- income level also influences the elasticity. E.g. Rich man will not curtail the consumption quantity of
fruit, milk etc, even if their price rises, but a poor man will not follow it.

6. Amount of money spend on the commodity- where an individual spends only a small portion of his income on the
commodity, the price change doesn‟t materially affect the demand for the commodity, and the demand is inelastic...
(match box, salt Etc)

7. Durability of commodity- if the commodity is durable or repairable at a substantially less amount (eg.Shoes), the
demand for that is elastic.
8. Purchase frequency of a product/time –if the frequency of purchase of a product is very high, the demand is likely to be
more price elastic.
9. Range of Prices- if the products at very high price or at very low price having inelastic demand since a slight change in
price will not affect the quantity demand.
10. Others – the habit of consumers, demand for complimentary goods, distribution of income and wealth in the society
etc., are other important factors affecting elasticity.
REMEMBER THE FORMULAS

How Do We Interpret the Income Elasticity of Demand?

Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the
income elasticity, the more sensitive demand for a good is to income changes. A very high income elasticity suggests that
when a consumer's income goes up, consumers will buy a great deal more of that good. A very low price elasticity implies
just the opposite, that changes in a consumer's income has little influence on demand.

CHAPTER 3 – SUPPLY CONCEPTS

SUPPLY

Supply also involves the relationship between price and quantity.

Supply is the quantity of goods and services that producers are willing to offer at various possible prices.

Law of Supply

The Law of Supply is a direct relationship between price and quantity supplied.

The Law of Supply states that producers will offer more of a product at higher prices and less of a product at lower prices.
Producers supply more goods and services when they can sell them at higher prices. They will supply fewer goods and
services when they must sell them at lower prices.

Supply Schedule

A supply schedule shows the relationship between the price of a good and the quantity producers are willing to supply.

The supply schedule lists each quantity of a product that producers are willing to supply at various market prices.

Supply schedules and curves are a snapshot because they represent a specific time period.
Supply curves

A supply curve plots the information from a Supply Schedule on a graph. This allows us to easily and quickly make
decisions on supply.

Normal supply curves reflect a steady relationship between quantity and price, like the graph on the right.

Elasticity of Supply

Degree to which price changes affect the quantity supplied. There are two sides, elastic and inelastic.

Elastic- when a small change in price causes a major change in the quantity supplied.

Inelastic- when a change in price does not affect the quantity supplied.

The Big Idea: A small increase in the cost of production may result in a cut back in quantity supplied.

Supply Shifts

Supply can change for a variety of reasons other than price including:

1. price of resources
✓ Any price increase or decrease in resources will effect their costs
✓ Resources include raw materials, electricity and workers’ wages.

2. government tools
✓ Tools include taxes, subsidies and regulation, which can change how much a company is willing to produce
✓ Taxes: payment to fund government services. Taxes add to cost of production
✓ Subsidies: payments to private businesses to ensure an affordable supply of some essential goods like dairy,
wheat, etc.
✓ Regulations: rules on how a business can operate which are meant to protect the consumer

3. technology
✓ New technology can reduce the costs of production, leading to an increase in supply.

4. competition
✓ Competition increases supply because there are more companies producing similar goods.
Example: As new video game consoles come out, the demand for new games increases. As such, more suppliers come to
the market, creating plenty of supply.

5. prices of related goods

✓ Suppliers may choose to produce different goods which are selling for a higher profit.
Example: farmer growing wheat will want to switch to growing corn if the price of corn goes up.

6. producer expectations
✓ If the producers think the demand for or the price of their products will increase they will increase their supply.

Equilibrium

The goal of supply and demand is to reach equilibrium between the two. By reaching the equilibrium there are exactly
enough goods to be sold, at a price the producers are willing to supply at. All items will be sold, and there will be nothing
left over, nor anyone still demanding the product.
 CHAPTER 4– MARKET STRUCTURES

MARKET STRUCTURES

Introduction The determination of price of the product is an important managerial function. Price affects profit through its
effect both on revenue and cost, profit is concerned with the difference between cost and the revenue .It always depends
on cost and volume of sales. Therefore the management always tries to find out the optimum combination of price and
output which offers the maximum profit to the firm. Thus pricing occupies on important place in economic analysis of
firms. The knowledge of market and market structure with which a firm operates is more helpful in price output decisions.
Market in economic term means a meeting place where buyers and sellers deal directly or indirectly. Clark and Clark
defines market as that “any body of persons who are in intimate business relations and carry on extensive transactions in
any commodity”. Market structures are different market forms based on the degree of competition prevailing in the
market.

Perfect Competition

The term perfect competition is used in wider sense. perfect competition means all the buyers and sellers in the market are
aware of price of products .The following are the characteristics of perfectly competitive market
1. Large number of buyers and sellers in the market
2. Homogeneous product
3. Free entry or exit
4. All the buyers and sellers in the market have perfect knowledge about the market conditions.
5. Perfect mobility of factor of production
6. Absence of transportation costs.

When the first three assumptions are satisfied there exists pure competition .competition becomes perfect only when all
the assumptions are satisfied . In perfect competition ,the demand for the output for each producer is perfectly elastic
.With the larger number of firms and homogeneous products, no individual firm is in a position to influence the price .
Monopoly

Monopoly means `single `selling. In brief, monopoly is a market situation in which there is only one seller or producer of
a product for which no close substitution is available .As there is only one firm under monopoly, that single firm
constitutes the whole industry .The monopolist can fix price of his product and can pursue an independent price policy. A
monopolist can take the decision about the price of his product .For ex:- electricity , water supply companies etc.

Features The following are the important features of monopoly:

1. One seller and a large number of buyers.

2. No close substitutes for the product.
3. Monopolist is not the price taker and the price maker.
4. Monopolist can control the supply.
5. No entry of new firm to the market.
6. Firm and industry are the same

Causes of Monopoly

1. Legal restrictions
2. Exclusive ownership or control over the raw materials.
3. Economies of large scale production
4. Exclusive knowledge of a production technique.

Difference between perfect competition and Monopoly

1. Under perfect competition there are many sellers but in the case of monopoly, there is only one seller
2. Individual seller has no control over the market supply in the case of perfect competition. But in the case of Monopoly
individual seller controls the supply.
3. Products are identical in the case of perfect competition, but there is only one product in the case of Monopoly.
4. Under perfect competition, there are free entry and exit of firms .But the Monopolist blocks the entry.
5. The Monopolist discriminates the price but there is uniform price in perfect competition.
6. Firm and Industry is different in the case of perfect competition, they are same in the case of Monopoly.

Monopolistic Competition

In the present World market, it can be seen that there is no monopoly and there is no real competition. There is a mix up
of the two. This situation is generally known as Monopolistic competition. According to Prof .E. H Chemberlin of
America, Monopolistic Competition means a market situation In which competition is imperfect . The products of the
firms under monopolist competition , are mainly close substitutes to each other .

Features /Assumptions of Monopolistic Competition.

The following are the important features of Monopolistic Competition.

1. There are large numbers of producers or sellers

2. It deals with differentiated products.
3. There are free entry and exit of firms to the markets.
4. The selling cost determines the demand for the products.
5. There is no association of firms
6. There is no price competition.
7. There is lack of knowledge of the market.

Perfect Competition Monopolistic Competition

Products are identical Products are differentiated
It is not a real concept It is real concept .
Large Number of buyers and sellers Buyers and Sellers are not so large
Perfect knowledge of market Condition Lack of perfect knowledge of market Condition
Selling Cost do not play any role Selling cost has an important role
They are price takers They are price markers

Oligopoly

Oligopoly is a situation in which there are so few sellers that each of them is conscious of the results upon the price of the
supply. Which he individually places upon the market. According to J .Stigler `Oligopoly is that situation in which a firm
bases its market policy in part on the expected behavior of a few close revels`. Further, they may produce homogeneous or
differentiated products.

Characteristics

Oligopoly is a distinct market condition. It has the following features:

1. The firms are inter dependent in decision making .

2. Advertising should be effective.
3. Firms should have group behavior.
4. Indeterminateness of demand curve .
5. The number of firms or producers or sellers are very small .
6. Product are identical or close substitutes to each other
7. There is an element of Monopoly

Price Determination Under Oligopoly

Pricing many be in condition of independent pricing, pricing under-price leadership and pricing under collusion.

An oligopolist always guesses about his competitors’ reaction. They assume that if one decides to decrease the price, the
others will also reduce the price. The assumption is that each oligopolist will act and react in a way that keep condition
tolerable for all the members of the industry. If one firm reduces the price of the product, the others will be compelled to
reduce the price. But sometimes, if one increases the price, the other will not increase the price. The firms in Oligopoly do
not increase the prices due to the possibility of losing the customers to rivals who do not raise their prices. Firms usually
do not change their price in response to small changes in costs.

Pricing Under Collusive Oligopoly

The term Collusion means `to play together`. To avoid the competition among the firms, monopolistic firms arrive at a
formal agreement called cartel . It is common sales agency formed to eliminate competition and fix such a price and
output that will maximize profit of member firms. The firms output and price are determined by this cartel .
PRICE

Price is the monetary value of a good, service or resource established during a transaction. Price can be set by a seller or
producer when they possess monopoly power, and are said to be price makers, or set through the market itself, when firms
are price takers. Price can also be set by the buyer when they posses some monopsony power.

Pricing under Price Leadership

The price leadership means the leading firm determines the price and others follow it. All the firms in the industry adjusts,
the price fixed by the price leader. The large firm, who fixes the price, is known as the price maker and the firms, who
follow it are known as price –takers. The price leadership may be four types. They are:

1. Dominant price leadership- In this situation, there exists many small firms and one large firm and the large firm fixes
the price and the small firms in the market accept that price .
2. Barometric Price Leadership- Under this situation one reputed and experienced firm fixes the price and others may
follow it.
3. Aggressive Price Leadership– Under this market condition, one dominating firm fixes the price and they compel all
others in the industry to follow the price.
4. Effective Price Leadership- Under this condition, there are small number of firms in the industry.

Price Discrimination

A monopolist is in a position to fix the price of his product .He enjoys the control of supply of the product . A monopolist
is able to charge different price for his products to the different customers. This is known as price discrimination .
According to Mrs. John Robinson „the act of selling the same article , produced under single control at different prices to
different buyers is known as price discrimination. This is also known as differential pricing.

Types of Price Discrimination

1. Price relatively elastic portion of the demand curve of the first degree – charging different price for different persons for
the same product.
2. Price discrimination of the second degree – Under this, the buyers are classified into different divisions.
3. Price discrimination of the third degree – Here, the markets are divided according to elasticity of demand.

Conditions of Price Discrimination

There are three conditions to be satisfied to apply the price discrimination They are:

1. There must be more than one separate market

2. The markets must have different elasticity of demand
3. The market should be such that no buyer of the market may enter the other market and vice versa

Dumping

When monopolist works in home market as well as foreign market, he is able to discriminate the price between these two
markets, If he has monopoly in home market, and he faces competition in to foreign market, he will be able to charge
higher prices for his products in home market. This practice is known as dumping` or `price dumping.