Lecture Notes Managerial Economics

managerial economics and business strategy lecture notes and what is managerial economics and financial analysis and how managerial economics helps in decision making
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MANAGERIAL ECONOMICS Study material COMPLEMENTARY COURSE For I SEMESTER B.COM/BBA. (2011 Admission) UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION CALICUT UNIVERSITY P.O. MALAPPURAM, KERALA, INDIA - 673 635 409 School of Distance Education MODULE I INTRODUCTION Introduction 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‟. Actually economics broadened into a full fledged social science in the th later half of the 18 century. Definition of Economics Classical economists like Adam Smith, Ricardo, Mill Malthus and others; socialist economist like Karl Marx; neo-classical economists like Alfred Marshall, AC Pigou and Lionel Robbins and modern economists like JM Keynes, Samuelson and others have made considerable contribution to the development of Economics. Hence a plethora of definitions are available in connection with the subject matter of economics. These are broadly divided into A. Wealth Definition, B. Welfare Definition, C. Scarcity Definition and D. Growth Definition 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”. But this definition was severely criticized by highlighting the points like; Too much emphasis on wealth, Restricted meaning of wealth, No consideration for human feelings, No mention for man‟s welfare Silent about economic problem etc… 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. Prof. A C Pigou was also holding Marshall‟s view. This definition clarified the scope of economics and rescued economics from the grip of being called “Dismal science”, but this definition also criticized on the grounds that welfare cannot be measured correctly and it was ignored the valuable services like teachers,lawyers,singers etc (non-material welfare) Managerial Economics-I Sem.B.Com/BBA 5 School of Distance Education C. Scarcity Definition After Alfred Marshall, 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. The merits of scarcity definition are; this definition is analytical, universal in application, a positive study and considering the concept of opportunity cost. But this also criticized on the grounds that; it is too narrow and too wide, it offers only light but not fruit, confined to micro analysis and ignores Growth economics etc.. 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”. Main features of growth definition are; it is applicable even in barter economy, the inclusion of time element makes the scope of economics dynamic and it is an improvement in scarcity definition. Meaning and Definition of Managerial Economics. Managerial Economics as a subject gained popularit-y in U.S.A after the publication of the book “Managerial Economics” by Joel Dean in 1951. Joel Dean observed that 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. According to Prof. Evan J Douglas, 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-I Sem.B.Com/BBA 6 School of Distance Education Spencer and Siegleman defined 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. Cristopor I Savage and John R Small opinioned that “managerial economics is some thing that concerned with business efficiency”. In the words of Michael Baye,”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... 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. Managerial Economics-I Sem.B.Com/BBA 7 School of Distance Education 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., also. 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 labour and capital market. 6. Government economic policies viz., industrial policy, monitory policies, fiscal policy, price policy etc… Managerial Economics-I Sem.B.Com/BBA 8 School of Distance Education 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? Etc... 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) Macro economics 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-I Sem.B.Com/BBA 9 School of Distance Education 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. 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. 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 Forward planning 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. Managerial Economics-I Sem.B.Com/BBA 10 School of Distance Education Economics Vs Managerial economics. Economics Managerial Economics 1. Dealing only micro aspects 1. Dealing both micro and macro aspects 2. Only a normative science. 2. Both positive and normative science. 3. Deals with practical aspects. 3. Deals with theoretical aspects 4. Study the problems of firm only. 4. Study both the firm and individual. 5. Narrow scope. 5. Wide scope Self check questions. Fill in the blanks. (Weightage-1/4) 1. The famous book on economics “An Enquiry into the Nature and Cause of Wealth of Nation” was written by………… 2. ……………. is known as the „father of economics”. 3. Welfare definition of economics is given by…………….. 4. The scarcity definition is suggested by………. 5. …………… bridges the gap between traditional economic theory and real business practices Short answer type (Weightage -1) 1. Define managerial economics? 2. What is the difference between business economics and managerial economics? 3. What is scarcity definition? 4. What you mean by decision making? 5. What is forward planning? 6. What is economic problem? Short essay type (Weightage -2) 1) Define Managerial economics? What are its basic characteristics? 2) What are the responsibilities of managerial economist? 3) What is decision making? What are its elements or steps? 4) Distinguish between economics and managerial economics? Essay type (Weightage -4) 1) Define Managerial economics? Explain the scope of managerial economics? 2) Explain role and functions and responsibilities of managerial economists? Managerial Economics-I Sem.B.Com/BBA 11 School of Distance Education MODULE II DEMAND CONCEPTS 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. In the opinion of Stonier and Hague, “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. The concept of law of demand may be explained with the help of a demand schedules. 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. Managerial Economics-I Sem.B.Com/BBA 12 School of Distance Education Price of Apple Quantity (In Rs.) demanded 10 1 8 2 6 3 4 4 2 5 When the price falls from Rs 10 to 8, 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; The demand curve DD 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. Market Demand Schedule for egg. Price per Demand by consumers Market dozen(Rs) A B C D Demand 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 Managerial Economics-I Sem.B.Com/BBA 13 School of Distance Education 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 Rs.10, A buys one dozen and B buys 2 dozens. When price falls to Rs.8, A buys 2 , B buys 3 and C buys one dozen. When price falls to Rs.6, 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,ie,”Market Demand” as given below; 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? Demand curve slopes downward from left to right (Negative Slope). There are many causes for downward sloping of demand curve:- 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) Principle of Equi- Marginal Utility Consumer will arrange his purchases in such a way that the marginal utility is equal in all his purchases. If it is not equal, they will alter their purchases till the marginal utility is equal. Managerial Economics-I Sem.B.Com/BBA 14 School of Distance Education 3) 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. 4) 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. 5) 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... 6) Psychology of people. Psychologically people buy more of a commodity when its price falls. In other word it can be termed as price effect. 7) Tendency of human beings to satisfy unsatisfied wants. 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. Managerial Economics-I Sem.B.Com/BBA 15 School of Distance Education 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. Exceptional Demand Curve (perverse demand curve) 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 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 etc... Managerial Economics-I Sem.B.Com/BBA 16 School of Distance Education 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. 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. Shift in demand cannot be shown in same demand curve. The increase and decrease in demand (upward shift and downward shift) can be expressed by the following diagram. Managerial Economics-I Sem.B.Com/BBA 17 School of Distance Education DD 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. Comparison between extension/contraction and shift in demand SL. Extension/Contraction of Demand Shift in Demand No 1 Demand is varying due to changes in Demand is varying due to price changes in other factors 2 Other factors like taste, preferences, Price of commodity remain the income etc... remaining the same. same 3 Consumer moves along the same Consumer may moves to higher demand curve or lower demand curve Different types of demand. Joint demand: When two or more commodities are jointly demanded at the same time to satisfy a particular want, it is called joint or complimentary demand.(demand for milk, sugar, tea for making tea). Composite demand: The demand for a commodity which can be put for several uses (demand for electricity) Direct and Derived demand: Demand for a commodity which is for a direct consumption is called direct demand.(food, cloth). When the commodity is demanded as s result of the demand of another commodity, it is called derived demand.(demand for tyres depends on demand of vehicles). Industry demand and company demand: Demand for the product of particular company is company demand and total demand for the products of particular industry which includes number of companies is called industry demand Managerial Economics-I Sem.B.Com/BBA 18 School of Distance Education 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 three types of elasticity of demand: 1. Price Elasticity of Demand. 2. Income Elasticity of Demand. and 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 Ep = Change in Quantity demanded / Quantity demanded Change in Price/price OR Ep = (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. 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= ∞) Managerial Economics-I Sem.B.Com/BBA 19 School of Distance Education 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 Managerial Economics-I Sem.B.Com/BBA 20 School of Distance Education 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 SL No type Numerical description Shape of curve expression 1 Perfectly elastic α infinity Horizontal 2 Perfectly inelastic 0 Zero Vertical 3 Unitary elastic 1 One Rectangular hyperbola 4 Relatively elastic 1 More than Flat one 5 Relatively inelastic 1 Less than Steep one 3.3 Income Elasticity of Demand Income elasticity of demand shows the change in quantity demanded as a result of a change in consumers‟ income. Income elasticity of demand may be stated in the form of formula: Ey = Proportionate Change in Quantity Demanded 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. Managerial Economics-I Sem.B.Com/BBA 21 School of Distance Education 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. Managerial Economics-I Sem.B.Com/BBA 22 School of Distance Education Advertisement Elasticity of Demand Advertisement elasticity of demand (Promotional elasticity of demand) measure the responsiveness of demand due to a change in advertisement and other promotional expenses. This can be measured by the following formula; Advertisement Elasticity = Proportionate Increase in Sales Proportionate increase in Advertisement expenditure. There are various determinants of advertisement elasticity, they are; 1. Type of commodity- elasticity will be higher for luxury, new product, growing product etc., 2. Market share – larger the market share of the firm lower will be promotional elasticity. 3. Rival‟s reaction – if the rivals react to increase in firm‟s advertisement by increasing their own advertisement expenditure, it will reduce the advertisement elasticity of the firm. 4. State of economy – if economic conditions are good, the consumers are more likely to respond to the advertisement of the firm. Advertisement elasticity helps in the process of decision making. It helps to deciding the optimum level of advertisement and promotional cost. If the advertisement elasticity is high, it is profitable to spend more on advertisement. Hence, advertisement elasticity helps to decide optimum advertisement and promotional outlay. 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. 8. Others- The concept elasticity of demand also helping in taking other vital decision Eg.Determining the price of joint product, take over decision etc.. Managerial Economics-I Sem.B.Com/BBA 23

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