managerial economic bba unit -i

7/28/2019 Managerial Economic BBA Unit -I

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LESSON1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics has

become more popular and seems to displace Business Economics.

DECISION-MAKING AND FORWARD PLANNING

The chief function of a management executive in a business firm is

decision-making and forward planning. Decision-making refers to theprocess of selecting one action from two or more alternative courses of

action. Forward planning on the other hand is arranging plans for the

future. In the functioning of a firm the question of choice arises

because the available resources such as capital, land, labour and

management, are limited and can be employed in alternative uses. The

decision-making function thus involves making choices or decisions

that will provide the most efficient means of attaining an

organisational objectives, for example profit maximization. Once a

decision is made about the particular goal to be achieved, plans for

the future regarding production, pricing, capital, raw materials and

labour are prepared. Forward planning thus goes hand in hand with

decision-making. The conditions in which firms work and take

decisions, is characterised with uncertainty. And this uncertainty not

only makes the function of decision-making and forward planning

complicated but also adds a different dimension to it. If the knowledge

of the future were perfect, plans could be formulated without error

and hence without any need for subsequent revision. In the real

world, however, the business manager rarely has complete

information about the future sales, costs, profits, capital conditions.

etc. Hence, decisions are made and plans are formulated on the basis

of past data, current information and the estimates about future that

are predicted as accurately as possible. While the plans are


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implemented over time, more facts come into the knowledge of the

businessman. In accordance with these facts the plans may have to be

revised, and a different course of action needs to be adopted.

Managers are thus engaged n a continuous process of decision-making through an uncertain future and the overall problem that they

deal with is adjusting to uncertainty.

To execute the function of decision-making in an uncertain

frame-work, economic theory can be applied with considerable

advantage. Economic theory deals with a number of concepts and

principles relating to profit, demand, cost, pricing, production,

competition, business cycles and national income, which are aided byallied disciplines like accounting. Statistics and Mathematics also can

be used to solve or at least throw some light upon the problems of

business management. The way economic analysis can be used

towards solving business problems constitutes the subject matter of

Managerial Economics.

DEFINITION

According to McNair the Merriam, Managerial Economics consists of

the use of economic modes of thought to analyse business situations.

Spencer and Siegelman have defined Managerial Economics as

the integration of economic theory with business practice for the

purpose of facilitating decision-making and forward planning by

management.

The above definitions suggest that Managerial economics is the

discipline, which deals with the application of economic theory to

business management. Managerial Economics thus lies on the margin

between economics and business management and serves as the

bridge between the two disciplines. The following Figure 1.1 shows the

relationship between economics, business management and

managerial economics.


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APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT

The application of economics to business management or the

integration of economic theory with business practice, as Spencer and

Siegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts of economicsin relation to the actual business behavior and conditions:

In economic theory, the technique of analysis is that of model

building. This involves making some assumptions and, drawing

conclusions on the basis of the assumptions about the behavior

of the firms. The assumptions, however, make the theory of the

firm unrealistic since it fails to provide a satisfactory

explanation of what the firms actually do. Hence, there is need

to reconcile the theoretical principles based on simplified

assumptions with actual business practice and developappropriate extensions and reformulation of economic theory.

For example, it is usually assumed that firms aim at maximising

profits. Based on this, the theory of the firm suggests how much

the firm will produce and at what price it would sell. In practice,

however, firms do not always aim at maximum profits (as they

may think of diversifying or introducing new product etc.) To

that extent, the theory of the firm fails to provide a satisfactoryexplanation of the firms actual behavior. Moreover, in actual


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business language, certain terms like profits and costs have

accounting concepts as distinguished from economic concepts.

In managerial economics, an attempt is made to merge the

accounting concepts with the economics, an attempt is made tomerge the accounting concepts with the economic concepts.

This helps in a more effective use of financial data related to

profits and costs to suit the needs of decision-making and

forward planning.

Estimating economic relationships: This involves themeasurement of various types of elasticities of demand such as

price elasticity, income elasticity, cross-elasticity, promotionalelasticity and cost-output relationships. The estimates of these

economic relationships are to be used for the purpose of

forecasting.

Predicting relevant economic quantities: Economic quantitiessuch as profit, demand, production, costs, pricing and capital

are predicated in numerical terms together with their

probabilities. As the business manager has to work in anenvironment of uncertainty, the future needs to be foreseen so

that in the light of the predicted estimates, decision-making and

forward planning may be possible.

Using economic quantities in decision-making and forwardplanning: This involves formulating business policies for

establishing future business plans. This nature of economic

forecasting indicates the degree of probability of various possibleoutcomes, i.e., losses or gains that will occur as a result of

following each one of the available strategies. Thus, a quantified

picture gets set up, that indicates the number of courses open,

their possible outcomes and the quantified probability of each

outcome. Keeping this picture in view, the business manager is

able to decide about which strategy should be chosen.

Understanding significant external forces: Applying economictheory to business management also involves understanding the


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important external forces that constitute the business environment

and with which a business must adjust. Business cycles,

fluctuations in national income and government policies pertaining

to taxation, foreign trade, labour relations, antimonopolymeasures, industrial licensing and price controls are typical

examples. The business manager has to appraise the relevance and

impact of these external forces in relation to the particular

business unit and its business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

There are certain chief characteristics of managerial economics, which

can help to understand the nature of the subject matter and help in aclear understanding of the following terms:

Managerial economics is micro-economic in character. This isbecause the unit of study is a firm and its problems. Managerial

economics does not deal with the entire economy as a unit of

study.

Managerial economics largely uses that body of economicconcepts and principles, which is known as Theory of the Firmor Economics of the Firm. In addition, it also seeks to apply

profit theory, which forms part of distribution theories in

economics.

Managerial economics is concrete and realistic. I avoids difficultabstract issues of economic theory. But it also involves

complications ignored in economic theory in order to face the

overall situation in which decisions are made. Economic theoryignores the variety of backgrounds and training found in

individual firms. Conversely, managerial economics is

concerned more with the particular environment that influences

decision-making.

Managerial economics belongs to normative economics ratherthan positive economics. Normative economy is the branch of

economics in which judgments about the desirability of variouspolicies are made. Positive economics describes how the


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economy behaves and predicts how it might change. In other

words, managerial economics is prescriptive rather than

descriptive. It remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations amongdifferent variables without judging what is desirable or

undesirable. For instance, the law of demand states that as

price increases, demand goes down or vice-versa but this

statement does not imply if the result is desirable or not.

Managerial economics, however, is concerned with what

decisions ought to be made and hence involves value

judgments. This further has two aspects: first, it tells what aimsand objectives a firm should pursue; and secondly, how best to

achieve these aims in particular situations. Managerial

economics, therefore, has been described as normative

microeconomics of the firm.

Macroeconomics is also useful to managerial economics since itprovides an intelligent understanding of the business

environment. This understanding enables a business executiveto adjust with the external forces that are beyond the

managements control but which play a crucial role in the well

being of the firm. The important forces are: business cycles,

national income accounting, and economic policies of the

government like those relating to taxation foreign trade, anti-

monopoly measures and labour relations.

DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS ANDECONOMICS

The difference between managerial economics and economics can be

understood with the help of the following points:

Managerial economics involves application of economicprinciples to the problems of a business firm whereas;

economics deals with the study of these principles only.

Economics ignores the application of economic principles to theproblems of a business firm.


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Managerial economics is micro-economic in character, however,Economics is both macro-economic and micro-economic.

Managerial economics, though micro in character, deals onlywith a firm and has nothing to do with an individuals economicproblems. But microeconomics as a branch of economics deals

with both economics of the individual as well as economics of a

firm.

Under microeconomics, the distribution theories, viz., wages,interest and profit, are also dealt with. Managerial economics on

the contrary is mainly concerned with profit theory and does not

consider other distribution theories. Thus, the scope ofeconomics is wider than that of managerial economics.

Economic theory assumes economic relationships and buildseconomic models. Managerial economics adopts, modifies and

reformulates the economic models to suit the specific conditions

and serves the specific problem solving process. Thus,

economics gives the simplified model, whereas managerial

economics modifies and enlarges it. Economics involves the study of certain assumptions like in the

law of proportion where it is assumed that The variable input

as applied, unit by unit is homogeneous or identical in amount

and quality. Managerial economics on the other hand,

introduces certain feedbacks. These feedbacks are in the form of

objectives of the firm, multi-product nature of manufacture,

behavioral constraints, environmental aspects, legal constraints,constraints on resource availability, etc. Thus managerial

economics, attempts to solve the complexities in real life, which

are assumed in economics. this is done with the help of

mathematics, statistics, econometrics, accounting, operations

research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICS


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Certain other expressions like economic analysis for business

decisions and economics of business management have also been

used instead of managerial economics but they are not so popular.

Sometimes expressions like Economics of the Enterprise, Theory ofthe Firm or Economics of the Firm have also been used for

managerial economics. It is, however, not appropriate t use theses

terms because managerial economics, though primarily related to the

economics of the firm, differs from it in the following respects:

First, Economics of the Firm deals with the theory of the firm,which is a body of economic principles relating to the firm alone.

Managerial economics on the other hand deals with the,application of the same principles to business.

Secondly, the term Economics of the firm is too simple in itsassumptions whereas managerial economics has to reckon with

actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no generaluniform pattern. However, the following aspects may be said to be

inclusive under managerial economics:

Demand analysis and forecasting. Cost and production analysis. Pricing decisions, policies and practices. Profit management. Capital management.

These aspects may also be defined as the Subject-Matter of

Managerial Economics. In recent years, there is a trend towards

integrations of managerial economics and operations research. Hence,

techniques such as linear programming, inventory models and theory

of games have also been regarded as a part of managerial economics.

Demand Analysis and Forecasting


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A business firm is an economic Organisation, which transforms

productive resources into goods that are to be sold in a market. A

major part of managerial decision-making depends on accurate

estimates of demand. This is because before production schedules canbe prepared and resources are employed, a forecast of future sales is

essential. This forecast can also guide the management in maintaining

or strengthening the market position and enlarging profits. The

demand analysis helps to identify the various factors influencing

demand for a firms product and thus provides guidelines to

manipulate demand. Demand analysis and forecasting, thus, is

essential for business planning and occupies a strategic place inmanagerial economics. It comprises of discovering the forces

determining sales and their measurement. The chief topics covered in

this are:

Demand determinants Demand distinctions Demand forecasting.

Cost and Production Analysis

A study of economic costs, combined with the data drawn from the

firms accounting records, can yield significant cost estimates. These

estimates are useful for management decisions. The factors causing

variations in costs must be recognised and thereby should be used for

taking management decisions. This facilitates the management toarrive at cost estimates, which are significant for planning purposes.

An element of cost uncertainty exists in this because all the factors

determining costs are not always known or controllable. Therefore, it

is essential to discover economic costs and measure them for effective

profit planning, cost control and sound pricing practices. Production

analysis is narrower in scope than cost analysis. The chief topics

covered under cost and production analysis are: Cost concepts and classifications


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Cost-output relationships Economics of scale Production functions Cost control.

Pricing Decisions, Policies and Practices

Pricing is a very important area of managerial economics. In fact price

is the origin of the revenue of a firm. As such the success of a usiness

firm largely depends on the accuracy of price decisions of that firm.

The important aspects dealt under area, are as follows:

Price determination in various market forms Pricing methods Differential pricing product-line pricing and price forecasting.

Profit Management

Business firms are generally organised with the purpose of making

profits. In the long run, profits provide the chief measure of success.

In this connection, an important point worth considering is the

element of uncertainty existing about profits. This uncertainty occurs

because of variations in costs and revenues. These are caused byfactors such as internal and external. If knowledge about the future

were perfect, profit analysis would have been a very easy task.

However, in a world of uncertainty, expectations are not always

realised. Thus profit planning and measurement make up the difficult

area of managerial economics. The important aspects covered under

this area are:

Nature and measurement of profit. Profit policies and techniques of profit planning.

Capital Management

Among the various types and classes of business problems, the most

complex and troublesome for the business manager are those relating

to the firms capital investments. Capital management implies

planning and control and capital expenditure. In this procedure,

relatively large sums are involved and the problems are so complex

that their disposal not only requires considerable time and labour but


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also top-level decisions. The main elements dealt with cost

management are:

Cost of capital

Rate of return and selection of projects.The various aspects outlined above represent the major uncertainties,

which a business firm has to consider viz., demand uncertainty, cost

uncertainty, price uncertainty, profit uncertainty and capital

uncertainty. We can, therefore, conclude that managerial economics is

mainly concerned with applying economic principles and concepts to

adjust with the various uncertainties faced by a business firm.

USES OF MANAGERIAL ECONOMICSManagerial economics achieves several objectives. The principal

objectives are as follows:

It presents those aspects of traditional economics, which arerelevant for business decision-making in real life. For this

purpose, it picks from economic theory those concepts,

principles and techniques of analysis, which are concerned with

the decision-making process. These are adapted or modified insuch a way that it enables the manager to take better decisions.

Thus, managerial economics attains the objective of building a

suitable tool kit from traditional economics.

Managerial economics also incorporates useful ideas from otherdisciplines such as psychology, sociology, etc. If they are found

relevant for decision-making. In fact, managerial economics

takes the aid of other academic disciplines that are concernedwith the business decisions of a manager in view of the various

explicit and implicit constraints subject to which resource

allocation is to be optimised.

It helps in reaching a variety of business decisions even in acomplicated environment. Certain examples of such decisions

are those decisions concerned with:

oThe products and services to be produced

o The inputs and production techniques to be used


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o The quantity of output to be produced and the sellingprices to be subscribed

o The best sizes and locations of new plantso

Time of replacing the equipmento Allocation of the available capital

Managerial economics helps a manager to become a morecompetent model builder. Thus, he can pick out the essential

relationships, which characterise a situation and leave out the

other unwanted details and minor relationships.

At the level of the firm, functional specialists or functionaldepartments exist, e.g., finance, marketing, personnel,production etc. For these various functional areas, managerial

economics serves as an integrating agent by co-ordinating the

different areas. It then applies the decisions of each department

or specialist, those implications, which are pertaining to other

functional areas. Thus managerial economics enables business

decision-making to operate not with an inflexible and rigid but

with an integrated perspective. This integration is importantbecause the functional departments or specialists often enjoy

considerable autonomy and achieve conflicting goals.Managerial

economics keeps in mind the interaction between the firm and

society and accomplishes the key role of business as an agent

in attaining social economic welfare. There is a growing

awareness that besides its obligations to shareholders, business

enterprise has certain social obligations as well. Managerialeconomics focuses on these social obligations while taking

business decisions. By doing so, it serves as an instrument of

furthering the economic welfare of the society through socially

oriented business decisions.

Thus, it is evident that the applicability and usefulness of

managerial economics is obtained by performing the following

activates:

Borrowing and adopting the tool-kit from economic theory.


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Incorporating relevant ideas from other disciplines to achievebetter business decisions.

Serving as a catalytic agent in the course of decision-making bydifferent functional departments/specialists at the firms level.

Accomplishing a social purpose by adjusting business decisionsto social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS

Economic theory offers a variety of concepts and analytical tools that

can assist the manager in the decision-making practices. Problem

solving in business has, however, found that there exists a widedisparity between the economic theory of a firm and actual observed

practice, thus necessitating the use of many skills and be quite useful

to examine two aspects in this regard:

The basic tools of managerial economics which it has borrowedfrom economics, and

The nature and extent of gap between the economic theory ofthe firm and the managerial theory of the firm.

Basic Economic Tools in Managerial Economics

The most significant contribution of economics to managerial

economics lies in certain principles, which are basic to the entire

range of managerial economics. The basic principles may be identified

as follows:

1.Opportunity Cost Principle

The opportunity cost of a decision means the sacrifice of alternatives

required by that decision. This can be best understood with the help

of a few illustrations, which are as follows:

The opportunity cost of the funds employed in ones ownbusiness is equal to the interest that could be earned on those

funds if they were employed in other ventures.


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The opportunity cost of the time as an entrepreneur devotes tohis own business is equal to the salary he could earn by seeking

employment.

The opportunity cost of using a machine to produce one productis equal to the earnings forgone which would have been possible

from other products.

The opportunity cost of using a machine that is useless for anyother purpose is zero since its use requires no sacrifice of other

opportunities.

If a machine can produce either X or Y, the opportunity cost ofproducing a given quantity of X is equal to the quantity of Y,which it would have produced. If that machine can produce 10

units of X or 20 units of Y, the opportunity cost of 1 X is equal

to 2 Y.

If no information is provided about quantities produced, exceptabout their prices then the opportunity cost can be computed in

terms of the ratio of their respective prices, say Px/Py.

The opportunity cost of holding Rs. 500 as cash in hand for oneyear is equal to the 10% rate of interest, which would have been

earned had the money been kept as fixed deposit in a bank.

Thus, it is clear that opportunity costs require the ascertaining

of sacrifices. If a decision involves no sacrifice, its opportunity

cost is nil.

For decision-making, opportunity costs are the only relevant

costs. The opportunity cost principle may be stated as under:The cost involved in any decision consists of the sacrifices of

alternatives required by that decision. If there are no sacrifices, there

is no cost.

Thus in macro sense, the opportunity cost of more guns in an

economy is less butter. That is the expenditure to national fund for

buying armour has cost the nation of losing an opportunity of buying

more butter. Similarly, a continued diversion of funds towards defence


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spending, amounts to a heavy tax on alternative spending required for

growth and development.

2. Incremental PrincipleThe incremental concept is closely related to the marginal costs andmarginal revenues of economic theory. Incremental concept involves

two important activities which are as follows:

Estimating the impact of decision alternatives on costs andrevenues.

Emphasising the changes in total cost and total cost and totalrevenue resulting from changes in prices, products, procedures,

investments or whatever may be at stake in the decision.The two basic components of incremental reasoning are as follows:

Incremental cost: Incremental cost may be defined as thechange in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change intotal revenue resulting from a particular decision.

The incremental principle may be stated as under:

A decision is obviously a profitable one if:o It increases revenue more than costso It decreases some costs to a greater extent than it

increases other costs

o It increases some revenues more than it decreases otherrevenues

o It reduces costs more that revenues.Some businessmen hold the view that to make an overall profit,

they must make a profit on every job. Consequently, they refuse

orders that do not cover full cost (labour, materials and overhead) plus

a provision for profit. Incremental reasoning indicates that this rule

may be inconsistent with profit maximisation in the short run. A

refusal to accept business below full cost may mean rejection of a

possibility of adding more to revenue than cost. The relevant cost is

not the full cost but rather the incremental cost. A simple problem willillustrate this point.


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IIIustration

Suppose a new order is estimated to bring in additional revenue of Rs.

5,000. The costs are estimated as under:

Labour Rs. 1,500Material Rs. 2,000

Overhead (Allocated at 120% of labour cost) Rs. 1,800

Selling administrative expenses

(Allocated at 20% of labour and material cost) Rs. 700

Total Cost Rs. 6,000

The order at first appears to be unprofitable. However, suppose,if there is idle capacity, which can be, utilised to execute this order

then the order can be accepted. If the order adds only Rs. 500 of

overhead (that is, the added use of heat, power and light, the added

wear and tear on machinery, the added costs of supervision, and so

on), Rs. 1,000 by way of labour cost because some of the idle workers

already on the payroll will be deployed without added pay and no

extra selling and administrative cost then the incremental cost ofaccepting the order will be as follows.

Labour Rs. 1,500

Material Rs. 2,000

Overhead Rs. 500

Total Incremental Cost Rs. 3,500

While it appeared in the first instance that the order will resultin a loss of Rs. 1,000, it now appears that it will lead to an addition of

Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does

not mean that the firm should accept all orders at prices, which cover

merely their incremental costs. The acceptance of the Rs. 5,000 order

depends upon the existence of idle capacity and labour that would go

unutilised in the absence of more profitable opportunities. Earleys

study of excellently managed large firms suggests that progressive

corporations do make formal use of incremental analysis. It is,


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however, impossible to generalise on the use of incremental principle,

since the observed behaviour is variable.

3.Principle of Time Perspective

The economic concepts of the long run and the short run have become

part of everyday language. Managerial economists are also concerned

with the short-run and long-run effects of decisions on revenues as

well as on costs. The actual problem in decision-making is to maintain

the right balance between the long-run and short-run considerations.

A decision may be made on the basis of short-run considerations, but

may in the course of time offer long-run repercussions, which make itmore or less profitable than it appeared at first. An illustration will

make this point clear.

IIIustration

Suppose there is a firm with temporary idle capacity. An order for

5,000 units comes to managements attention. The customer is willing

to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.

The short-run incremental cost (ignoring the fixed cost) is only Rs.

3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per

unit (Rs. 5,000 for the lot. However, the long-run repercussions of the

order ought to be taken into account are as follows:

If the management commits itself with too much of business atlower prices or with a small contribution, it may not have

sufficient capacity to take up business with higher

contributions when the opportunity arises. The management

may be compelled to consider the question of expansion of

capacity and in such cases; even the so-called fixed costs may

become variable.

If any particular set of customers come to know about this lowprice, they may demand a similar low price. Such customers

may complain of being treated unfairly and feel discriminated.

In response, they may opt to patronise manufacturers with


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more decent views on pricing. The reduction or prices under

conditions of excess capacity may adversely affect the image of

the company in the minds of its clientele, which will in turn

affect its sales.It is, therefore, important to give due consideration to the time

perspective. The principle of time perspective may be stated as under:

A decision should take into account both the short-run and long-run

effects on revenues and costs and maintain the right balance between

the long-run and short-run perspectives.

Haynes, Mote and Paul have cited the case of a printing

company. This company pursued the policy of never quoting pricesbelow full cost though it often experienced idle capacity and the

management was fully aware that the incremental cost was far below

full cost. This was because the management realised that the long-run

repercussions of pricing below full cost would make up for any short-

run gain. The management felt that the reduction in rates for some

customers might have an undesirable effect on customer goodwill

particularly among regular customers not benefiting from price

reductions. It wanted to avoid crating such an image of the firm that

it exploited the market when demand was favorable but which was

willing to negotiate prices downward when demand was unfavorable.

4. Discounting PrincipleOne of the fundamental ideas in economics is that a rupee tomorrow

is worth less than a rupee today. This seems similar to the saying that

a bird in hand is worth two in the bush. A simple example would

make this point clear. Suppose a person is offered a choice to make

between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will

choose the Rs. 100 today.

This is true for two reasons. First, the future is uncertain and

there may be uncertainty in getting Rs. 100 if the present opportunity

is not availed of. Secondly, even if he is sure to receive the gift in

future, todays Rs. 100 can be invested so as to earn interest, say, at 8

percent so that. one year after the Rs. 100 of today will become Rs.


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108 whereas if he does not accept Rs. 100 today, he will get Rs. 100

only in the next year. Naturally, he would prefer the first alternative

because he is likely to gain by Rs. 8 in future. Another way of saying

the same thing is that the value of Rs. 100 after one year is not equalto the value of Rs. 100 of today but less than that. To find out how

much money today is equal to Rs. 100 would earn if one decides to

invest the money. Suppose the rate of interest is 8 percent. Then we

shall have to discount Rs. 100 at 8 per cent in order to ascertain how

much money today will become Rs. 100 one year after. The formula is:

V =

Rs. 100

1 + iwhere,

V = present value

i = rate of interest.

Now, applying the formula, we get

V =

Rs. 100

1 + i

=1001.08

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,

which will accumulate at 8 per cent after one year.

92.59 x 1.08 = 99.0072

= 1.00

The same reasoning applies to longer periods. A sum of Rs. 100two years from now is worth:

V =

Rs. 100

=

Rs. 100

=

Rs. 100

(1+i)2 (1.08)2 1.1664

Similarly, we can also check by computing how much the

cumulative interest will be after two years. The principle involved in

the above discussion is called the discounting principle and is stated

as follows: If a decision affects costs and revenues at future dates, it


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is necessary to discount those costs and revenues to present values

before a valid comparison of alternatives is possible.

5. Equi-marginal PrincipleThis principle deals with the allocation of the available resource

among the alternative activities. According to this principle, an input

should be allocated in such a way that the value added by the last

unit is the same in all cases. This generalisation is called the equi-

marginal principle.

Suppose a firm has 100 units of labour at its disposal. The firm

is engaged in four activities, which need labour services, viz., A, B, Cand D. It can enhance any one of these activities by adding more

labour but sacrificing in return the cost of other activities. If the value

of the marginal product is higher in one activity than another, then it

should be assumed that an optimum allocation has not been attained.

Hence it would, be profitable to shift labour from low marginal value

activity to high marginal value activity, thus increasing the total value

of all products taken together. For example, if the values of certain two

activities are as follows:

Value of Marginal Product of labour

Activity A = Rs. 20

Activity B = Rs. 30

In this case it will be profitable to shift labour from A to activity

B thereby expanding activity B and reducing activity A. The optimum

will be reach when the value of the marginal product is equal in all the

four activities or, when in symbolic terms:

VMPLA = VMPLB = VMPLC = VMPLD

Where the subscripts indicate labour in respective activities.

Certain aspects of the equi-marginal principle need

clarifications, which are as follows:

First, the values of marginal products are net of incrementalcosts. In activity B, we may add one unit of labour with an

increase in physical output of 100 units. Each unit is worth 50


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paise so that the 100 units will sell for Rs. 50. But the increased

output consumes raw materials, fuel and other inputs so that

variable costs in activity B (not counting the labour cost) are

higher. Let us say that the incremental costs are Rs. 30 leavinga net addition of Rs. 20. The value of the marginal product

relevant for our purpose is thus Rs. 20.

Secondly, if the revenues resulting from the addition of labourare to occur in future, these revenues should be discounted

before comparisons in the alternative activities are possible.

Activity A may produce revenue immediately but activities B, C

and D may take 2, 3 and 5 years respectively. Here thediscounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal product mayhave to be corrected if the expansion of an activity requires an

alternative reduction in the prices of the output. If activity B

represents the production of radios and it is not possible to sell

more radios without a reduction in price, it is necessary to make

adjustment for the fall in price. Fourthly, the equi-marginal principle may break under

sociological pressures. For instance, du to inertia, activities are

continued simply because they exist. Similarly, due to their

empire building ambitions, managers may keep on expanding

activities to fulfil their desire for power. Department, which are

already over-budgeted often, use some of their excess resources

to build up propaganda machines (public relations offices) towin additional support. Governmental agencies are more prone

to bureaucratic self-perpetuation and inertia.


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MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting

the management in using the increasingly specialised skills and

sophisticated techniques, required to solve the difficult problems of

successful decision-making and forward planning. In business

concerns, the importance of the managerial economist is therefore

recognised a lot today. In advanced countries like the USA, largecompanies employ one or more economists. In our country too, big

industrial houses have understood the need for managerial

economists. Such business firms like the Tatas, DCM and Hindustan

Lever employ economists. A managerial economist can contribute to

decision-making in business in specific terms. In this connection, two

important questions need be considered:

1.What role does he play in business, that is, what particularmanagement problems lend themselves to solution through

economic analysis?

2. How can the managerial economist best serve management, thatis, what are the responsibilities of a successful managerial

economist?

Role of a Managerial Economist


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One of the principal objectives of any management in its decision-

making process is to determine the key factors, which will influence

the business over the period ahead. In general, these factors can be

divided into two categories: External InternalThe external factors lie outside the control of management

because they are external to the firm and are said to constitute

business environment. The internal factors lie within the scope and

operations of a firm and hence within the control of management, and

they are known as business operations. To illustrate, a business firmis free to take decisions about what to invest, where to invest, how

much labour to employ and what to pay for it, how to price its

products, and so on. But all these decisions are taken within the

framework of a particular business environment, and the firms degree

of freedom depends on such factors as the governments economic

policy, the actions of its competitors and the like.

Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general

business conditions, for example, prices, national income and output,

volume of trade, etc., are of great significance since they affect every

business firm. Certain important relevant factors to be considered in

this connection are as follows:

The outlook for the national economy, the most important local,regional or worldwide economic trends, the nature of phase of

the business cycle that lies immediately ahead.

Population shifts and the resultant ups and downs in regionalpurchasing power.

The demand prospects in new as well as established markets.Impact of changes in social behaviour and fashions, i.e.,

whether they will tend to expand or limit the sales of acompanys products, or possiblymake the products obsolete?


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The areas in which the market and customer opportunities arelikely to expand or contract most rapidly.

Whether overseas markets expand or contract and the affect ofnew foreign government legislations on the operation of theoverseas plants?

Whether the availability and cost of credit tend to increase ordecrease buying, and whether money or credit conditions ahead

are likely to easy or tight?

The prices of raw materials and finished products. Whether the competition will increase or decrease. The main components of the five-year plan, the areas where

outlays have been increased and the segments, which have

suffered a cut in their outlays.

The outlook to governments economic policies and regulationsand changes in defence expenditure, tax rates tariffs and import

restrictions.

Whether the Reserve Banks decisions will stimulate or depressindustrial production and consumer spending and how will

these decisions affect the companys cost, credit, sales and

profits.

Reasonably accurate data regarding these factors can enable the

management to chalk out the scope and direction of their own

business plans effectively. It will also help them to determine the

timing of their specific actions. And it is these factors, which present

some of the areas where a managerial economist can make effectivecontribution. The managerial economist has not only to study the

economic trends at the micro-level but also must interpret their

relevance to the particular industry or firm where he works. He has to

digest the ever-growing economic literature and advise top

management by means of short, business-like practical notes. In

mixed economy like that of India, the managerial economist

pragmatically interprets the intentions of controls and evaluates theirimpact. He acts as a bridge between the government and the industry,


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translating the governments intentions and transmitting the reactions

of the industry. In fact, the government policies emerge out of the

performance of industry, the expectations of the people and political

expediency.

Business Operations

A managerial economist can also be helpful to the management in

making decisions relating to the internal operations of a firm in

respect of such problems as price, rate of operations, investment,

expansion or contraction. Certain relevant questions in this context

would be as follows: What will be a reasonable sales and profit budget for the next

year?

What will be the most appropriate production schedules andinventory policies for the next six months?

What changes in wage and price policies should be madenow?

How much cash will be available next month and how shouldit be invested?

Specific Functions

The managerial economists can play a further role, which can cover

the following specific functions as revealed by a survey pertaining to

Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:

Sales forecasting.

Industrial market research. Economic analysis of competing companies. Pricing problems of industry. Capital projects. Production programmes. Security / Investment analysis and forecasts. Advice on trade and public relations.


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Advice on primary commodities. Advice on foreign exchange. Economic analysis of agriculture. Analysis of underdeveloped economics. Environmental forecasting.

The managerial economist has to gather economic data, analyse all

relevant information about the business environment and prepare

position papers on issues facing the firm and the industry. In the case

of industries prone to rapid theological advances, the manager may

have to make continuous assessment of tl1e impact of changing

technology. The manager' may need to evaluate the capital budget in

the light of short and long-range financial, profit and market

potentialities. Very often, he also needs to prepare speeches for the

corporate executives. It is thus clear that in practice, managerial

economists perform many and various functions. However, of all

these, the marketing functions, i.e., sales force listing an industrial

market research, are the most important.

For this purpose, the managers may collect statistical records of

the sales performance of their own business and those rehiring to

their rivals, carry out analysis of these records and report on trends in

demand, their market shares, and the relative efficiency of their retail

outlets. Thus, while carrying out heir functions, the managers may

have to undertake detailed statistical analysis. There are, of course,

differences in the relative importance of the various functions

performed from firm to firm and in the degree of sophistication of the

methods used in performing these functions. But there is no doubt

that the job of a managerial economist requires alertness and the

ability to work uriderpressure.

Economic Intelligence

Besides these functions involving sophisticated analysis, managerial


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economist may also provide general intelligence service. Thus the

economist may supply the management with economic information of

general interest such as competitors

prices and products, tax rates, tariff rates, etc.

Participating in Public Debates

Many well-known business economists participate in public debates.

The government and society alike are seeking their advice and views.

Their practical experience in business and industry adds prestige to

their views. Their public recognition enhances their protg in the

.firm itself.

Indian Context

In the Indian context, a managerial economist is expected to perform

the following functions:

Macro-forecasting for demand and supply.

Production planning at macro and micro levels. Capacity planning and product-mix determination. Economics of various production lines. Economic feasibility of new production lines / processes and

projects.

Assistance in preparation of overall development plans. Preparation of periodical economic reports bearing on various

matters such as the company's product-lines, future growth

opportunities, market pricing situation, general business,. and

various national/international factors affecting industry and

business.

Preparing briefs; speeches, articles and papers for topmanagement for various chambers, Committees, Seminars,

Conferences, etc

Keeping management informed of various national and

International Developments on economic/industrial matters.

With the adoption of the new economic policy, the macro-


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economic environment is changing fast and these changes have

tremendous implications for business. The managerial economists

have to playa much more significant role. They ha'1e to constantly

measure the possibilities of translating the rapidly changing economicscenario into workable business opportunities. As India marches

towards globalisation, the managerial economists will have to interpret

the global economic events and find out how the firm can avail itself of

the various export opportunities or of establishing plants abroad

either wholly owned or in association with local partners.

Responsibilities of a Managerial Economist

Besides considering the opportunities that lie before a managerial

economist it is necessary to take into account the services that are

expected by the management. For this, it is necessary for a

managerial economist to thoroughly recognise the responsibilities

and obligations. A managerial economist can serve the management

best by recognising that the main objective of the business, is to

make a profit on its invested capital. Academic training and the

critical comments from people outside the business may lead a

managerial economist to adopt an apologetic or defensive attitude

towards profits. There should be a strong personal conviction on part

of the managerial economist that profits are essential and it is

necessary to help enhance the ability of the firm to make profits.

Otherwise it is difficult to succeed in serving management.

Most management decisions necessarily concern the future, which

is rather uncertain. It is, therefore, absolutely essential that a

managerial economist recognises his responsibility to make

successful forecast. By making the best possible forecasts and

through constant efforts to improve, a managerial' ng, the risks

involved in uncertainties. This enables the management to follow a

more orderly course of business planning. At times, it is required for

the managerial economist to reassure the management that an

important trend will continue. In other cases, it is necessary to point


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out the probabilities of a turning point in some activity of importance

to management. In any case, managerial economist must be willing to

make fairly positive statements about impending economic

developments. These can be based upon the best possibleinformation and analysis. The management's confidence in a

managerial economist increases more quickly and thoroughly with

a record of successful forecasts, well documented in advance and

modestly evaluated when the actual results become available.

A few consequences to the above proposition need also be

emphasised here.

First, a managerial economist has a major responsibility to alertmanagelI1ent at the earliest possible moment in' case there is an

err6r' in his forecast. This will assist the mallagement in making

appropriate adjustment in policies and programmes and

strengthen his oWn position as a member of the management

team by keeplrighis fingers on the economic pulse of the

business.

Secondly, a managerial economist must establish and maintainmany contacts with individuals and data sources: which would

not be immediately available to the other members of the

management. Extensive familiarity with reference sources and

material is essential. It is still more important that the known

individuals who are specialists in particular fields have a bearing

on tpe managerial economist's work. For this purpose, it is

required that managerial economist joins professional

associations and tak~ active part in them. In fact, one of the best

means of determining the quality of a managerial economist is to

evaluate his ability to obtain information quickly by personal

contacts rather than by lengthy research from either readily

available or obscure reference sources. Within any business,

there' may be a wealth of knowledge and experience but the

managerial economist would be really useful ifit is possible pn


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his part to supplement the existing know-how with additional

information and in the quickest possible manner.

Again, if a managerial economist is to be really helpful to the

management in successful decision-making and forward planning, it

is necessary'" to able to earn full status on the business team.

Readiness to take up special assignments, be that in study teams,

committees or special projects is another important requirement. This

is because it is necessary for the managerial economist to win

continuing support for himself and his professional ideas. Clarity of

expression and attempting to minimise the use of technical

terminology while communJcating his ideas to management

executives is also an essential role so as to win approval.

To conclude, a managerial economist has a very important role to

play by helping management in successful decision-making and

forward planning. But to discharge his role successfully, it is

necessary to recognise the 'relevant responsibilities and obligations.

To some business executives, however, a managerial economist is still

a luxury or perhaps even a necessary evil. It is not surprising,

therefore, to find that while tneir status is improving and their

impor;ance is gradually rising, managerial economists in certain firms

still 'feel quite insecure. Nevertheless, there is a definite and growing

realisation that they can contribute significantly to the profitable

growth of firms and effective solution oftMir problems, and this'

promises them a positive future.


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LESSON2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of any

business firm. Firms are interested in their profit and sales, both

of which depend partially upon the demand for the product. The

decisions, which management makes with respect to production,

advertising, cost allocation, pricing, inventory holdings, etc. call

for an analysis of demand. While how much a firm can produce

depends upon its capacity and demand for its products. If there is

no demand for a product, its production is unworthy. If demand

falls short of production, one way to balance the two is to create

new demand through more and better advertisements. The more

the future demand for a product, the more inventories the firm

would hold. The larger the demand for a firm's product, the higher

is the price it can charge.

Demand analysis seeks to identify and measure the forces that

determine sales. Once this is done the alternative ways of

manipulating or managing demand can easily be inferred.

Although, demand for a finri's product reflects what the

consumers buy, this can be influenced through manipulating the

factors on which consumers base their demands. Demand

analysis attempts to estiinate the demand for a product in future,

which further helps to plan production based on the estimated

demand.

MEANING OF DEMAND

Demand for a good implies the desire of an individual to acquire the

product. It also includes willingness and ability of ail individual to

pay for the product. For example, a miser's desire for and his ability

to pay for a car is not demand, for he does not have the necessary

will to pay for the car. Similarly, a poor person's desire for and his


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willingness to pay for a car is not demand because he lacks the

necessary purchasing power. One can also imagine an individual,

who possesses both the will and the purchasing power to pay for a

good. But this purchasing power is not the demand for that good,this is because he does not have the desire to buy that product.

Therefore, demand is successful when there are all the three factors:

desire, willingness and ability. It should also be noted that demand

for any goods or services has no meaning unless it is stated with

reference to time, price, competing product, consumer's incomes,

tastes and preferences. This is because demand varies with

fluctuations in these factors. For example, the demand for anAmbassador car in India is 40,000 is meaningless unless it is stated

that this was the demand in 1976 when an Ambassador car's price

was around thirty thousand rupees. The price of the competing cars

prices were around the same, a Bajaj scooter's price was around five

thousand rupees and petrol price was around three and a half

rupees per litre. In 1977, the demand for Ambassador cars could be

different if any of the above factors happened to be different.

Furthermore, it should be noted that a product is defined with

reference to its particular quality. If its quality changes it can be

deemed as another product. Thus, the demand for any product is

the desire, wi1lihigness and ability to buy the product with reference

to a partkular time and given values of variables on which it

depends.

TYPES OF DEMAND

The demand for various kinds of goods is generally classified on the

basis of kinds of consumers, suppliers of goods, nature of goods,

duration of consumption goods, interdependence of demand, period

of demand and nature of use of goods (intermediate or final), The

major classifications of demand are as follows:

Individual and market demand


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Demand for firm's prodtictand industry's products Autonomous and derived demand Demand for durable and non-durable goods Short-term and long-term demand

Individual and Market Demand

The quantity of a product, which an individual is willing to buy at a

particular price during a specific time period, given his money

income, his taste, and prices of other commodities (particularly

substitutes and complements), is called 'individual's demand for a

product'. The total quantity, which all comsumers are willing to buy

at a given price per time unit, given their money income, taste, and

prices of other commodities is known as 'market demand for the

good'. In other words, the market demand for a good is the sum of

the individual demands of all the c6-nsumers of a product, over a

time period at given prices.

Demand for Firm's Product and Industry's ProductsThe quantity of a firm's yield, that can be disposed of at a given price

over a period refers to the demand for firm's product. The aggregate

demand for the product of all firms of an industry is known as the

market-demand or demand for industry's product. This distinction

between the two kinds of demand is not of much use in a highly

competitive market since it merely signifies the distinction between a

sum and its parts. However, where market structure is oligopolistic,a distinction between the demand for firm's product and industry's

product is useful from managerial point of view. The product of each

firm is so differentiated from the products of the rival firms that

consumers treat each product different from the other. This gives

firms an opportunity to plan the price of a product, advertise it in

order to capture a larger market share thereby to enhance profits.

For instance, market of cars, radios, TV sets, refrigerators, scooters,toilet soaps and toothpaste, all belong to this category of markets.


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In case of monopoly and perfect competition, the distinction

between demand for a firm's product and industry's product is not

of much use from managerial point of view. In case of monopoly,

industry is one-firmindustiy andthe demand for firm's product is thesame as that of the industry. In case of perfect competition,

products of all firms .of the industry are homogeneous and price for

each firm is determined by industry. Firms have little opportunity to

plan the prices permissible under local conditions and

advertisement by a firm becomes effective for the whole industry.

Therefore, conceptual distinction between demand for film's product

and industry's product is not much use in business decisionsmaking.

Autonomous and Derived Demand

An Autonomous demand for a product is one that arises

independently of the demand for any other good whereas a derived

demand is one, which is derived from demand of some other good. To

look more closely at the distinction between the two kinds of demand,

consider the demand for commodities, which arise directly from the

biological or physical needs of the human beings, such as demand for

food, clothes and shelter. The demand for these goods is autonomous

demand. Autotnomous demand also arises as a' result of

demonstration effect, rise in income, and increase in population and

advertisement of new produCts. On the other hand, the demand for a

good that arises because of the demand for some other good is called

derived demand. For instance, demand for land, fertiliser and

agricultural tools and implements are derived demand, since the

demand of goods, depends on the demand of food. Similarly, demand

for steel, bricks, cement etc., is a derived demand because it is

derived from the demand for houses and other kind of buildings. [n

general, the demand for, producer goods or industrial inputs is a

derived one. Besides, demand for complementary goods (which

complement the use of other goods) or for supplementary goods


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(which supplement or provide additional utility from the use of other

goods) is a derived demand. For instance petrol is a complementary

goods for automobiles and a chair is a complement to a table.

Consider some examples of supplement goods. Butter is supplementto bread, mattress is supplement to cot and sugar is supplement to

tea. Therefore, demand for petrol, chair, and sugar would be

considered as derived demand. The conceptual distinction between

autonomous demand and derived demand would be useful according

to the point of view of a bllsinessman to the extent the former can

serve as an indicator of the latter.

Demand for Durable and Non-durable Goods

Demand is often classified under demand for durable and non-durable

goods. Durable goods are those goods whose total utility is not

exhausted in single or short-run use. Such goods can be used

continuously over a period of time. Durable goods may be consumer

goods as well as producer goods. Durable consumer goods include

clothes, shoes, house furniture, refrigerators, scooters, and cars. The

durable producer goods include mainly the items under fixed assets,

such as building, plant and machinery, office furniture and fixture.

The durable goods, both consumer and producer goods, may be

further classified as semi-durable goods such as, clothes and

furniture and durable goods such as residential and factory buildings

and cars. On the other harid, non-durable goods are those goods,

which can be used only once such as food items and their total utility

is exhausted in a single use. This category of goods can also be

grouped under non-durable consumer and producer goods. All food

items such as drinks, soap, cooking fuel, gas, kerosene, coal and

cosmetics fall in the former category whereas, goods such as raw

materials', fuel and power, finishing materials and packing items come

in the latter category.

The demand for non-durable goods depends largely on their

current prices, consumers' income and fashion whereas the expected


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price, income and change in technology influence the demand for the

durable good. The demand for durable goods changes over a relatively

longer period. There is another point of distinction between demands

for durable and non-durable goods. Durable goods create demand forreplacement or substitution of the goods whereas non-durable goods

do not. Also the demand for non-durable goods increases or decreases

with a fixed or constant rate whereas the demand for durable goods

increases or decreases exponentially, i.e., it may depend upon some

factors such as obsolescence of machinery, etg. For example, let us

suppose that the annual demand for cigarettes in a city is 10 million

packets and it increases at the rate of half-a-million packets perannum on account of increase in population when other factors

remain constant. Thus, the total demand for cigarettes in the next

year will be 10.5 million packets and 11 million packets in the next to

next year and so on. This is a linear increase in the demand for a non-

durable good like cigarette. Now consider the demand for a durable

good, e.g., automobiles. Let us suppose: (i1 the existing number of

automobiles in a city, in a year is 10,000, (ii) the annual replacement

demand equals 10 per cent of the total demand, and (iii) the annual

autonomous increase in demand is 1000 automobiles. As such, the

total annual clemand for automobiles in four subsequent years is

calculated and presented in Table 2.1.

Table 2.1: Annual Demand for Automobiles

Beginning Total no. of Replacement Annual Total Annualof the ear automobiles demand autonomous demand increase

Stock demand in

, demand1st year 10,000 - - 10,000 -

2nd year 10,000 1000 1000 12,000 2000

-3id year 12,000 1200 1000 14,200 2200

4th year 14,200 1420 1000 16,620 2420

Stock + Replacement + Autonomous demand = TotalDemand

It may be seen from the Table 2.1 that the total demand for

automobiles is increasing at an increasing rate due to acceleration


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in the replacement demand. Another factor, which might accelerate

the demand for automobiles and such durable goods, is the rate of

obsolescence of this category of goods.

Short-term and Long-term Demand

Short-term demand refers to the demand for goods that are demanoed

over a short period. In this category fall mostly the fashion consumer

goods, goods of seasonal use and inferior substitutes during the

scarcity period of superior goods. For instance, the demand for

fashion wears is short-term demand though the demand for the

generic goods such as trousers, shoes and ties continues to remain a

longterm demand. Similarly, demand for umbrella, raincoats,

gumboots, cold drinks and ice creams is of seasonal nature; 'The

demand for such goods lasts till the season lasts. Some goods of this

category are demanded for a very short period, i.e., 1-2 week, for

example, new greeting cards, candles and crackers on occasion of

diwali.

Although some goods are used only seasonally but are durable in

pature, e.g., electric fans, woollen garments, etc. The demand for such

goods is of also durable in nature but it is subject to seasonal

fluctuations. Sometimes, demand for certain gools suddenly increases

because of scarcity of their superior substitutes. For examp1e, when

supply of cooking gas suddenly decreases, demand for kerosene,

cooking coal and charcoal increases. In such cases, additional

demand is of shGrtterm nature. The long-term demand, on the hand,

refers to the demand, which exists over a long-period. The change in

long-term demand is visible only after a long period. Most generic

goods have long-term demand. For example, demand for consumer

and producer goods, durable and non-durable goods, is long-term

demand, though their different varieties or brands may have only

short-term demand. Short-term demand depends, by and large, on the

price of commodities, price of their substitutes, current disposable

income of the consumer, their ability to adjust their consumption


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pattern and their susceptibility to advertisement of a new product.

The long-term demand depends on the long-term income trends,

availability of better substitutes, sales promotion, and consumer

credit facility. The short-term and lcmg-term concepts of demand areuseful in designing new products for established producers, choice of

products for the new entrepreneurs, in pricing policy and in

determining advertisement expenditure.

DETERMIN!\NTS OF MARKET DEMAND

The knowledge of the determinants of market demand for a product

and the nature of relationship between the demand and its

determinants proves very helpful in analysing and estimating demand

for the product. It may be noted at the very outset that a host of

factors determines the demand for a product. In general, following

factors determine market demand for a good:

Price of the good- . Price of the related goods-substitutes, complements and

supplements

Level of consumers' income Consumers' taste and preferenceAdvertisement of the product

Consumers' expectations about future price and supplyposition

Demonstration effect and 'bend-wagon effect

Consumer-credit facility Population of the country Distribution pattern of national income.These factors also include factors such as off-season discounts

and gifts on purchase of a good, level of taxation and general social

and political environment of the country. However, all these factors

are not equally important. Besides, some of them are not

quantifiable. For example, consumer's preferences, utility,demonstration effect and expectations, are difficult to measure.


39/49

However, both quantifiable and non-quantifiable determinants of

demand for a product will be discussed.

1. Price of the Product

The price of a product is one of the most important determinants of

demand in the long run and the only determinant in the short run.

The price and quantity demanded are inversely related to each other.

The law of demand states that the quantity demanded of a good or a

product, which its consumers would like to buy per unit of time,

increases when its price falls, and decreases when its price increases,

provided the other factors remain' same. The assumption 'other

factors remaining same' implies that income of the consumers, prices

of the substitutes and complementary goods, consumer's taste and

preference and number of consumers remain unchanged. The price-

demand relationship assumes a much greater significance in the

oligopolistic market in which outcome of price war between a firm and

its rivals determines the level of success of the firm. The firms have to

be fully aware of price elasticity of demand for their own products and

that of rival firm's goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of

its related goods. The related goods may be the substitutes or

complementary goods.

Substitutes

Two goods are said to. be substitutes of each other if a change in price

of one good affects the deinand for the other in the same direction. For

instance goods X and Y are considered as substitutes for each other if

a rise in the price of X increase demand for Y, and vice versa. Tea and

coffee, hamburgers and hot-dog, alcohol and drugs are some examples

of substitutes in case of consumer goods by definition, the relation

between demand for a product and price of its substitute is of positive

nature. When, price of the substitute of a product (tea) falls (or


40/49

increase), the demand for the product falls (or increases). The

relationship of this nature is shown in Figure 2.1 and 2.2.

Complementary Goods

A good is said to be a complement for another when it complements

the use of the other or when the two goods are used together in such a

way that their demand changes (increases or decreases)

simultaneously. For example, petrol is a complement to car and

scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,

mattress to cot, etc. Two goods are termed as complementary to each

other -i if an increase in the price of one causes a decrease in demand

for the other. By definition, there is an inverse relation between the

demand for a good and the price of its complement. For instance, an


41/49

increase in the price of petrol causes a decrease in the demand for car

and other petrol-run vehicles and vice versa while other thing's

remaining constant. The nature of relationship between the demand

for a product and the price of its complement is given in Figure 2.2.

3. Consume's Income

Income is the basic determinant of market demand since it

determines the purchasing power of a consumer. Therefore, people

with higher current disposable income spend a larger amount on

goods and services than those with lower income. Income-demand

relationship is of more varied nature than that between demand

and its other determinants. While other determinants of demand,

e.g., product's own price and the price ohts substitutes, are more

significant in the short-run, income as a determinant of demand is

equally important in both short run and long run. Before

proceeding further to discuss income-demand relationships, it will

be useful to note that consumer goods of different nature have

different kinds of relationship with consumers having different

levels of income. Hence, the managers need to be fully aware of the

kinds of goods they are dealing with and their relationship with the

income of consumers, particularly about the assessment of both

existing and prospective demand for a product.

For the purpose of income-demand analysis, goods and serv:ices

maybe grouped under four broad categories, which ate: (a) essential

consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige

or luxury goods. To understand all these terms, it is essential to

understand the relationship between income and different kinds of

goods.

Esscntial Consumcr Goods (ECG): The goods and services of this

category are called 'basic needs' and are consumed by all

persons of a society such as food-grains, salt, vegetable oils,

matches, cooking fuel, a minimum clothing and housing.

Quantity demanded for these goods increases with increase in


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consumer's income but only up to certain limit, even though the

total expenditure may increase in accordance with the quality of

goods consumed, other factors remaining the same. The

relationship between goods of this category and consumer'sincome is shown by the curve ECG in Figure 2.3. As the curve

shows, consumer's demand for essential goods increases only

until his income rises to OY2. It tends to saturate beyond this

level of income.

Inferior goods: Inferior goods are those goods whose demand

decreases with the increase in consumer's income. For example

millet is inferior to wheat and rice; bidi (indigenous cigarette) isinferior to cigarette, coarse, textiles are inferior to refined ones,

kerosene is inferior to cooking gas and travelling by bus is

inferior to travelling by taxi. The relation between income and

demand for an inferior good is shown by the curve IG in Figure

2.3 under the assumption that other determinants of demand

remain the same demand for such goods rises only up to a

certain level of income, i.e., OY1 and declines as income

increases beyond this level.


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Normal goods: Normal goods are those goods whose demand increases

with increaseiri the consumer income. For example, clothings,

household furniture and automobiles. The relation between incomeand demand for normal goods is shown by the curve NG in Figure 2.3.

As the curve shows, demand for such goods increases with the

increases in consumer income but at different rates at different levels

of income. Demand for normal goods increases rapidly with the

increase in the consumer's income but slows down with further

increase in income. It should be noted froms Figure 2.3 that up to

certain level of income (YI) the relation between income and demandfor all type of goods is similar. The difference is of only degree. The

relation becomes distinctly different beyond YI level of income.

Therefore, it is important to view the income-demand relations in the

light of the nature of product and the level fconsumer's income.

Prestige and luxury goods: Prestige goods are those goods, which areconsu!TIed mostly by rich section of the society, e.g., precious stones,

antiques, rare paintings, luxury cars and such other items of show-bff.

Whereas luxury goods include jewellery, costly brands of cosmetics, TV

sets, refrigerators, electrical gadgets and cars. Demand for such goods

arises beyond a certain level of consumer's income, i.e., consumption

enters the area of luxury goods. Producers of such goods, while

assessing the demand for their goods, should consider the income

changes in the richer section of the society and not only the per capita

income. The relation between income and demand for such goods isshown by the curve LG in Figure 2.3.

4. Consumer's taste and preference

Consumer's taste and preference play an important role in detennihing

demand for a product. Taste and preference depend, generally, on the

changing. life-style, social customs, religious values attached to a good,

habi of the people, the general levels of living of the society and age and sex


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of the consumers. Change in these factors changes consumer's taste and

preferences. As a result, consumers reduce or give up the consumption of

some goods and add new ones to their consumption pattern. For example,

following the change in fashion, people switch their consumption patternfrom cheaper, old-fashioned goods to costlier mod goods, as long as price

differentials are proportionate with their preferences. Consumers are

prepared to pay higher prices for 'mod goods' even if their virtual utility is

the same as that of old-fashioned goods. The manufacturers of goods and

services that are subject to frequent change in fashion and style, can take

advantage of this situation in two ways: (i) they can make quick profits by

designing new models of their goods and popularising them throughadvertisement, and (ii) they can plan production in abetter way and can

even avoid over-productiorlifthey keep an eye on the changing fashions.

5. Advertisel11ent Expenditure

Advertisement costs are incurred with the objective of increasing the

demand for the goods. This is done in the following ways:

By informing the potential consumers about the availability of thegoods.

By showing its superiority to the rival goods. By influencing consumers' choice against the rival goods, and By setting fashions and changing tastes.The impact of such effects shifts the demand curve upward to the

right.

In other words, when other factors' remain same, the expenditure onadvertisement increases the volume of sales to the same extent. The relation

between advertisement outlay and sales is shown in Figure 2.4.


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Assumptions

Therelatiqnship between demand and advertisement cost as shown in

Figure 2.4 is based on the following assumptions:

Consumers are fairly sensitive and responsive to various modesof advertisement.

The rival firms do not react to the advertisements made by afirm.

The level of demand has not already reached the saturation point.Advertisement beyond this point will make only marginal impact on

demand.

Per unit cost of advertisement added to the price does not make theprice prohibitive for consumers, as compared particularly to the price

of substitutes.

Others determinants of demand, e.g., income and tastes, etc., are notoperating in the reverse direction.

In the absence of these conditions, the advertisement effect on

sales may be unpredictable.

6. Consumers Expectations

Consumers expectations regarding the future prices, income and supply

position of goods play an important role in determining the demand for

goods and services in the short run. If consumers expect a rise in the price


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of a storable good, they would buy more of it at its current price with a view

to avoiding the possibility of price rise future. On the contrary, if consumers

expect a fall in the price of certain goods, they postpone their purchase with

a view to take advantage of lower prices in future, mainly in case of non-essential goods. This behaviour of consumers reduces the current demand

for the goods whose prices are expected to decrease in future. Similarly, an

expected increase in income increases the demand for a product. For

example, announcement of dearness allowance, bonus and revision of pay

scale induces increase in current purchases. Besides, if scarcity of certain

goods is expected by the consumers on account of reported fall in future

production, strikes on a large scale and diversion of civil supplies towardsthe military use causes the current demand for such goods to increase more

if their prices show an upward trend. Consumer demand more for future

consumption and profiteers demand more to make money out of expected

scarcity.

7. Demonstration Effect

When new goods or new models of existing ones appear in the market, rich

people buy them first. For instance, when a new model of car appears in

the market, rich people would mostly be the first buyer, Colour TV sets and

VCRs were first seen in the houses of the rich families some people buy

new goods or new models of goods because they have genuine need for

them. Some others do so because they want to exhibit their affluence. But

once new goods come in fashion, many households buy them not because

they have a genuine need for them but because their neighbors have

bought the same goods. The purchase made by the latter category of the

buyers are made out of such feelings' as jealousy, competition, equality in

the peer group, social inferiority and the desire to raise their social status.

Purchases made on account of these factors are the result of what

economists call 'demonstration effect' or the 'Band-wagon-effect.' These

effects have a positive effect on demand. On the contrary, when goods

become the thing of common use, some people, mostly rich, decrease or

give up the consumption of such goods. This is known as 'Snob Effect'. It


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has a negative effect'on the demand

for the related goods.

8. Consumer-Gredit Facility

Availability of credit to the cansumers fram the sellers, banks, relatians

and friends encourages the conSumers to buy more than what they would

buy in the aosence of credit availability. Therefore, the consumers who can

borrow more can consume more than those who cannot borrow. Credit

facility affects mostly the demand"for durable goods, particularly those,

which require bulk payment at the time of purchase. The car-loan facility

may be one reason why Delhi has more cars than Calcutta, Chennai and

Mumbai. Therefore, the managers who are assessing the prospective

demand for their goods should take into account the availability of credit to

the consumers.

9. Population of the Country

The Jotal domestic demand for a good of mass consumption depends also

on the size' of the population. Therefore, larger the population larger will be

the demand for a product, when price, per capita income, taste and

preference are given. With an increase or decrease in the size of population,

employment percentage remaining the same, demand for the product will

either increase or decrease.

10. Distribution of Na

managerial economic bba unit -i

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