MANAGERIAL ECONOMICS

“TEXT FOR THE SUBJECT”

“Managerial Economics – Analysis, Problems and Cases”

By

P. L. Mehta

Sultan Chand & Sons

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollacih.
 MANAGERIAL ECONOMICS
Evaluation Methodology:

1.1 Cycle Test.

2.Assignments (Questions) at the completion of each unit.
3.1 Model Examination.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollacih.
 WHAT IS MANAGERIAL ECONOMICS?

• Managerial Economics is Economics applied in Business Decision

Making.
• Serves as a link between Abstract Theory and Managerial Practice.
• Economic Analysis for:
• Identifying Problems
• Organizing Information
• Evaluating Alternatives
• Managerial Economics involves analysis of allocation of the resources
available to a firm or a unit of Management within that unit.
• Managerial Economics is:
• Goal Oriented
• Prescriptive
• Maximizing achievement of objectives

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollacih.
 MANAGERIAL ECONOMICS – DEFINITIONS

Mc Nair and Meriam defines:

“Managerial Economics is the use of Economic modes of thought to analyse
business situations”
Spencer and Siegelman:
“Managerial Economics is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by management”
Watson defines Managerial Economics as:
“Price theory in the service of business executives”
Brigham and Pappas defines:
“Managerial Economics is the application of economic theory and methodology to
business administration practice”.
Hague defines:
“Managerial Economics is the fundamental academic subject which seeks to
understand and to analyze the problems of business decision making”.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollacih.
 MANAGERIAL ECONOMICS – NATURE

1. Macro-economic Conditions: Decisions of firms are made within their economic

environment in which they operate. This environment is called Macro-economic conditions.
The Macro Economic conditions include:
1. A free enterprise economy using prices and market.
2. One undergoing rapid technological and economic change.
3. Increased intervention of government presently and in future.
2. Micro-economic Analysis: A study on Micro-economics help in understanding
1. What is going on within the firm.
2. How best to use the available scarce resources between various activities of the firm.
3. How to be technically as well as economically efficient.
1. Positive Vs Normative Approach: Positive Approach concerns with what is, was or will
be while Normative Approach concerns with what ought to be.
2. Integration of Economic Theory & Business Practice: Managerial Economist’s role is to
modify or extend the theoretical construct of economics to conform to actual business
behavior.

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STC - Pollacih.
 MANAGERIAL ECONOMICS - CHARACTERISTICS

• Microeconomic in character: Study restricted only to a firm and not on the working of the
economy.
• Takes the help of macroeconomics to understand and adjust to the environment in which
the firm operates.
• Normative than Positive in character (Prescriptive rather than Descriptive). It deals with
the type of decisions that the firm should take in order to prosper which involves value
judgments and not a mere description of behavior of the firm.
• Conceptual (to understand and analyze the decision problems) and Metrical (takes the
help of quantitative techniques to measure the impact of different factors and policies).
• Based mainly on “Theory of firm” and “Theory of distribution” (Analysis of Profits).
• Making wise choices (To face the problems of scarcities)
• The study of the allocation of resources available to a firm along the activities of that unit.
• It is goal oriented and maximize the objectives.

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 MANAGERIAL ECONOMICS - SIGNIFICANCE

• Provides a number of Tools and Techniques to enable a manager to capture the essential
relationships that represent the real situation eliminating relatively less important details.
• Provides most of the concepts such as:
• Elasticity of Demand
• Fixed and Variable Costs
• Short and Long Run Costs
• Opportunity Costs
• Net Present Value.
• Provides help in making decisions such as:
• What should be the product-mix
• Which is the production technique and the input-mix that is least costly.
• What should be the level of output and price of the product
• How to take investment decisions
• How much should the firm advertise
• How to allocate an advertisement fund between different media.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 MANAGERIAL ECONOMICS – SUBJECT MATTER

• The Subject matter of Managerial Economics consists

• Objectives of the Business Firm
• Demand Analysis and Demand Forecasting
• Production and Cost
• Competition
• Pricing and Output
• Profit
• Investment and Capital Budgeting
• Product Policy, Sales Promotion and Marketing Strategy

Prepared by Mr. R. Sriram, Lecturer - MBA,

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 MANAGERIAL ECONOMICS WITH VARIOUS
DISCIPLINES
Managerial Economics and Economics:
• Both the subjects have common ideals with identical problems.
• The problems of scarcity and resource allocation.
• The best ways of utilizing the labour and capital resources for achieving the set goals.
• The use of opportunity cost principle depicted in business is prevalent in general
economic theory.
• The study of types of markets (impact of markets or technological changes on
competitive position of the firm and their likely reactions).
Managerial Economics and Operations Research:
• Operations Research models are being used in Economics like Queuing, Linear
Programming, etc.
• Provides the manager with the tools he needs to carry out instant operations research.
Managerial Economics and Mathematics:
• It uses the metrical concepts available in mathematics to find estimate and predict the
relevant economic factors for decision making and forward planning.
• The descriptive research from mathematics is also used in managerial economics.

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 MANAGERIAL ECONOMICS WITH VARIOUS
DISCIPLINES (Contd…)
Managerial Economics and Statistics:
• Quantifying the past economic activity to predict its future (for correct judgment)
• Predict uncertainties raising in the firms
• Usage of Theory of probabilities in decision making
Managerial Economics and Theory of Decision Making:
• Single Objective – “Profit Maximization”.
• Theory of uncertainty creates new choices.
• It helps the executives to understand how managerial process combines and synthesizes
with various functional fields like:
• Sales Management
• Production Management
• It has close connections with various disciplines of knowledge like
• Traditional Economic Theory
• Statistics
• Operations Research

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 ROLE OF MANAGERIAL ECONOMIST

• He has TWO primary tasks namely

• Specific Decisions
• General Tasks
• Specific Decisions:
Specific Decisions are undertaken by the Managerial Economist in terms of
business operations which include shut down of operations of a plant, stay in business and
produce goods at optimum cost, making or buying decisions in business investments as
well as processing of goods. In performing these decisions, an economist undertakes the
following functions:
• Production Scheduling
• Demand Forecasting
• Market Research
• Economic Analysis of the Industry
• Investment Appraisal
• Security Management Analysis
• Advice on Foreign Exchange Management
• Advice on Trade
Prepared by Mr. R. Sriram, Lecturer - MBA,
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 ROLE OF MANAGERIAL ECONOMIST (Contd…)

• Specific Decisions:
• Pricing and the related decisions
• Analyzing and Forecasting environmental factors
• General Tasks:
• To know information which is necessary to make intelligent decisions
• To find the correct solution to a problem
• To learn how to process and use that information
• To check for economical feasibility of information obtained with theoretical and
statistical tools for decision making.
• Divided into two set of factors such as:
• External Factors – General Economic condition of the economy. (Demand,
Cost, Market Conditions, Market Share, Economic Policies)
• Internal Factors – Pricing and Profit Policies, Investment Decisions, ROI and
Cost of Investment.

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 FUNDAMENTAL CONCEPTS
• Managerial Economics covers several major concepts which includes:
• Incremental Reasoning – Covers the concepts of Incremental Costs and
Incremental Revenue. Incremental Costs is defined as the change in total cost as a
result of change in level of output, investment. Incremental Revenue is a change in
total revenue resulting from a change in the level of output, price etc.

• If the revenue generated from the original costs is Rs. 2000, then the company would
earn a loss of Rs. 400 while employing with original costs but when the company
plans to change its costs for earning additional revenue it earns a profit of Rs.600.
Prepared by Mr. R. Sriram, Lecturer - MBA,
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 FUNDAMENTAL CONCEPTS (Contd…)
• Incremental Reasoning is guided by the following two theorems:
• Theorem 1: A course of action should be pursued up to the point where its
incremental benefits equal its incremental costs.
• Theorem 2: Different courses of action should be pursued up to the point where all the
courses provide equal marginal benefit per unit of cost.
(It follows the Equi-Marginal Principle where the Marginal Utility of product x should be
equal to the Marginal Utility of product y).
• The concept of Opportunity Cost:
• It represents the benefits or revenue forgone by pursuing one course of action rather
than another.
“When a choice is made in favour of a particular alternative that appears to be most
desirable of all the given alternatives, it obviously implies that the next best alternative
has not been chosen”
Some illustrations:
a. The Opportunity cost of the funds employed in one’s own business is the amount of
interest which could have been earned had these funds been invested in the next best
channel of investment.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)
• Opportunity Cost Illustrations (Contd…):
b. When a product X rather than a product Y is produced by using a machine which can
produce both, the opportunity cost of producing X is the amount of Y sacrificed as a
result.
c. The opportunity cost of using an idle machine is zero, as its use needs no sacrifice of
opportunities.
d. The opportunity cost of one’s own business is the income one could have earned
accepting a job outside.
The sacrifices made on the opportunity cost principle can either be Monetary Costs which are
called as Explicit costs and the costs which are Social Costs are called Implicit Costs.
Explicit Costs: The Costs which are recognized in the accounts. It includes the Payments for
Labour, Raw Materials.
Implicit Costs: The Costs are sacrifices that are not recorded in accounts. It includes the Cost
of Capital supplied by owners of business.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)

Incremental Cost Opportunity Cost

1. Difference in Costs due to a Decision 1. Includes all the Economic Costs (rather
than Difference in Costs) of a scarce input.
2. By Subtracting incremental cost from 2. Opportunity Cost is subtracted from Total
incremental revenue, one can find the gain Revenue of the Chosen alternative to find the
from a proposed change in the activity. gain from the proposed use of the input.
3. The Incremental Cost concept is used to 3. Opportunity Costs focuses on the Net
show the contrast between the Sunk Costs Revenue that could be generated in the next
(the costs that do not change with the change best alternative use of a scarce resource.
in activity) and the costs that change with a
change in the level of business activity.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)
• Contribution:
• It tells us about the contribution of a unit of output to overheads and profit.
• It helps in determining the best product mix when allocation of scarce resources are
involved.
• It indicates whether or not it is advantageous to
• To accept fresh orders
• To introduce a new product
• To shut down
• To continue with the existing plant
• Unit contribution is the per unit difference of incremental revenue from incremental
cost.
• Introducing a new product at the time when the plant is run with backlog of orders
will require the company to compete with backlog and new product’s being
introduced. Here the contributions of the new product will be compared with existing
product
• In short, the contribution that each product makes in terms of the cost saving and
production is taken for calculation in deciding the best methods of production and
gaining better revenues.
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 FUNDAMENTAL CONCEPTS (Contd…)
• Time Perspective:
• The concept of Short Run and Long Run are introduced.
• The Short Run is approximately for a period of 3-5 years
• The Long Run is for a period of 15-20 years.
• Short Run is one where the concept of Fixed Input and Variable Inputs are being
used for producing goods. In the short run, the change in the output can be achieved
by changing the intensity of use of fixed inputs.
• Long Run is one where there are not fixed and variable inputs and all the
inputs(resources) are continuously changed to achieve the desired production levels.
In the long run, the change in the output can be achieved by a massive change in the
scale of resources mainly labour and capital.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)
• Discounting Principle (Time Value of Money (TVOM))
• The Concept of Discounting Principle is based on the fundamental fact that a rupee
now is worth than a rupee earned a year after. The discounting happens due to the fact
that the waiting period of our investments volunteers a sacrifice for the present. In
other words, the discounting involves the transaction costs for a particular
investment / Financial Transaction.
• For example, if a person A is given a choice of accepting Rs. 1000 today or next year,
he would rather accept it today since Rs.1000 invested today with an interest of 10%
would earn him Rs. 1,100.

• Formulae:
Discounted Value (v) =
Rk
-----------

(1+i)k

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STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)
• Risk and Uncertainty:
• Economic Theory assumes that the firm has perfect knowledge of its cost and demand
relationships and of its environment. Uncertainty is not allowed to influence the
decisions of the firm. The firm proceeds to maximize the profits after it has acquired
the relevant information on costs and revenue.
• Uncertainty influences the estimation of costs and revenues. Management deals with
decisions which have long term bearing, and since future conditions are not perfectly
predictable. There is always a sense of risk and uncertainty about the outcome of the
decisions.
• When a firm operates with other firms in the market, there is generally an element of
uncertainty regarding the actions and reactions of competitors. The Consumers shift
choices based on their level of satisfaction.
• Uncertainty can arise due to unexpected environmental changes such as,
(i) Changes in Governmental policies
(i) Changes in National and International Political Scenario
• Probability is widely used in assessing the uncertainty. The profit of a firm is
expected from the adoption of any action that may assume any value within a certain
range of values, each value having an associated probability of being realized.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 FUNDAMENTAL CONCEPTS (Contd…)
• Risk and Uncertainty (Contd…):
• The decision maker assigns these subjective probabilities to the possible profits of
each strategy and estimates its mathematical expectations.
• After having done such computations for all alternatives, the entrepreneur chooses
that action which gives the highest expected value.
• Computing the above is difficult since:
• Lot of information, knowledge, computational ability and time on the part of
managers which the firms lack
• The criterion of choosing an action with highest expected value is not adequate.
• A risk averter will choose a project which has low risk and low
bankruptcy.
• A risk lover will choose a project that has higher risk and higher
bankruptcy.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 OBJECTIVES OF THE FIRM
• The Objectives of the Firms can be categorised into two groups. They are
• The Optimising Models
• The Non-Optimising Models
• The Optimising Models can be further classified into the following:
• Profit Maximising Theories popularly known as the Theory of Firm
• Managerial Theories of the firm like
• Sales Revenue Maximisation Model
• Utility Models
• Growth Maximisation Models
• Behavioural Models – Satisficing Behaviour and Behavioural Theory of the
Firm.

Prepared by Mr. R. Sriram, Lecturer - MBA,

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 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL

• The Economists have been using this model for a long period of time.
• It has been developed on the basis of the assumption that rational firms pursue the objective
of profit maximisation, subject to the technical and market constraints.
• The Basic propositions are:
• The firm is a unit which transforms valued inputs into outputs of a higher value, given
the state of technology.
• The firm strives towards the achievement of goal – usually profit maximisation.
• The Market conditions (like competition, monopoly etc) for a firm to operate are
given.
• While choosing between alternatives, the firm prefers the alternative which helps it to
consistently achieve profit maximisation.
• The primary concern of the theory of firm is to analyse changes in the prices and
quantities of inputs and outputs.
• Assumptions:
• The firm has a single goal – to maximise profit (Motivational Assumption)
• The firm acts rationally to pursue its goal. Rationally implies perfect knowledge of all
relevant variables at the time of decision making (Cognitive Assumption)
• The firm is a single-ownership one i.e. run by its owner, called the entrepreneur.
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 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL
(Contd…)
• The term “Profit Maximisation” is usually the generation of largest absolute amount of
profits over the time period being analysed.
• The Time periods defined has been categorised into two broad periods: Short Run and
Long Run.
• Short Run is defined as period where adjustments to the changed conditions are only
partial. For Ex. If demand for the product of a firm increases, in the short run it can meet
the increased demand through changes in manhours and intensive use of existing
machinery but it cannot increase its production capacity.
• Long Run is a period where adjustment to changed circumstances is complete. Here a firm
can meet the increased demand in the long run by making changes in its production
capacity or by setting up an additional plant, besides changes in man-hours and intensive
use of its existing machinery.
• The relationship between short and long run profit maximisation is based on two
assumptions. (a) assumption of independence of periods (b) assumption of period linkages.
In the first assumption (a) both short and long run profit max. are consistent and identical.
But in the second assumption (b) the profit max. in the two periods may conflict. Few
examples could be (1) higher profits in the short run may in the long run induce workers to
demand higher wages. (2) max of profits in short run give an impression of being
exploitative inviting legal and govt. intervention which would affect long run profits.
Prepared by Mr. R. Sriram, Lecturer - MBA,
STC - Pollachi.
 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL
(Contd…)
• The Traditional Economic theory of Firm compares Costs and Revenue implications for
different output levels. It picks up the output level that maximises the absolute difference
between the two.
TR is taken as Total Revenue. TC is taken as Total Cost. Thus the Profit in economic terms
is the difference between Total Revenue and Total Cost.
Profit (∏ ) = Total Revenue (TR) – Total Cost (TC)
There are two conditions for attaining maximum value for ∏ . They are
First Condition:
• ∏ = Change in TR – Change in TC equals “ZERO”.
• Ə (∏ ) / Ə X = Ə (TR) / Ə X – Ə (TC) / Ə X equals “ZERO”.
Or
• Marginal Revenue (MR) = Marginal Cost (MC)
Second Condition:
• Ə2 ∏ / Ə X2 = Ə2 (TR) / Ə X2 – Ə2 (TC) / Ə X2 less than “ZERO”.
• Ə2 (TR) / Ə X2 < Ə2 (TC) / Ə X2
The above means the slope of MR curve is less than MC Curve.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL
(Contd…)
• There are several critiques of profit maximising theories. They are provided below
• Traditional economic theory assumes that the firm is owner-managed. Hence profit
maximisation implies the maximisation of income of owner. It would be the rational
behaviour of every owner managed enterprise since it counts his amount of effort
(reward for risk that the owner takes in his business).
• The Survival of the firm depends upon the owner’s (entrepreneur) ability to maximise
profits in long run. The competition between firms is forcing the owner to look for the
goals of profit maximisation. The objective here is to accumulate financial assets for
the company which allows it to grow faster than those firms which pursue other goals.
The situation is different in the case of Monopoly.
• Firms by working towards the goal of profit maximisation achieve other goals
including product quality, competitive edge and delivery.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL
(Contd…)
• The theory has been subjected to severe criticism. They are listed below:
• In the real business scenario the assumption of profit maximisation is a doubtful
validity. Every businessmen aim at sales maximisation, expansion of market share.
• A Firm is a complex organisation run by salaried manager whose interests may and
often differ from those of the shareholders who want maximum profits.
• The absence of incomplete information may be optimal. There are two types of lack
of information. They are
• Business directly or indirectly relate to the future. Since future is uncertain, the
decisions made by a person (businessman) may not be what he wants them to
be.
• The lack of information is due to the failure or inability of the firm to collect the
adequate information and to use the information it has.
• A Firm is split into may departments each of them carrying its operations. It is
certainly not possible for the firm to ensure that the decisions made fit well within the
overall policy framed for the organisation and whether it will be optimal or not. It
becomes complex for the firms to look upon them in a holistic view.
• It cannot be said that a firm in a non-competitive situation which does not maximise
its profits will be out of business even with changes in its economic environment. A
firm in the situation of the highest demand can still survive without changing its
systems if it remains among the large group of firms operating in business.
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 OPTIMISING MODEL – PROFIT MAXIMISATION MODEL
(Contd…)
• In the modern business world firms operate in dominant market structure such as Oligopoly
where few large firms dominate the market. The small firms have to follow these large
firms in pricing matters. Here how can these firms achieve the goal of PROFIT
MAXIMISATION.
• Lack of predictive power managers, firms with risk averse managers result in less than
maximum profit as their goal. This is mainly due to intra firm communication.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 OPTIMISING MODEL – SALES REVENUE MAXIMISATION
(BAUMOL’S)
• According to Baumol’s Model, the oligopolistic firms aim at maximising their sales
revenue. The various reasons are:
• Financial Institutions judge the health of a firm largely in terms of the rate of growth
of its sales revenue.
• There is evidence that slack earnings and salaries of Top management are correlated
more closely with the firms sales than with its profits.
• While increasing sales revenue over time provides prestige to the top management,
profits go to share holders.
• Growing sales help in keeping a health personnel policy, thus keeping employees
happy by giving them higher salaries and better terms, vice-versa if sales drop.
• Managers prefer “steady performance with satisfactory profits” than spectacular profit
maximisation projects. It is due to the reason that announcing spectacular profit as
goal will tend to push firms into profit making rather than revenue generation. If any
manager is unable to produce profits year-on-year then the firm shall penalise the
manager for non-achievement of the goal.
• Large sales will increase market share of the firm and prove its competitiveness in the
business.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 OPTIMISING MODEL – SALES REVENUE MAXIMISATION
(BAUMOL’S)
• Assumptions:
• Goal of the firm is sales maximisation to minimum profit constraint
• Advertisement is a major instrument of the firm as non-price competition is the
typical form of competition in oligopolistic markets
• Production costs are independent of advertising
• Advertisements create favorable conditions for the product. It will help sell larger
quantities of the product and earn larger revenue.
• Price of the product is assumed as constant.
• It is only after the profit constraint has been satisfied that profits become subordinate to
sales in the firm’s hierarchy of goals. (Only after setting the goals for minimum profits does
organisations start looking for the goals of Sales Maximisation)
• Implications of the Model (Refer Fig. 3.2 – Pg. No: 40)
• Both the profit maximiser and sales maximiser will face the same market condition,
sales maximiser will charge a lower price to sell extra output.
• A sales maximiser will spend more on advertising than a profit maximiser. The
advertisements will not affect the price but the objective here is to target an increased
sale of output to the consumer.
• Advertisements will increase the Total Cost of the firm but it will be until the profit
constraint is not disturbed.
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MANAGERIAL UTILITY MODELS – TRADITIONAL VIEW

Owners / Shareholders

Top-Level Management
(Board of Directors)

Middle-Level Management
(Line Managers, etc.)

Lower-Level Management
(Supervisory staff)

Workers

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MANAGERIAL UTILITY MODELS – MODERN VIEW

Share Holder

Blue Collar

White Collar

Tech & Sci

Mgmt

Prepared by Mr. R. Sriram, Lecturer - MBA,

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 BEHAVIOURAL THEORY OF FIRM - “SATISIFICING” MODEL
– H. A. SIMONS
• H. A. Simons proposes an alternative model to the profit maximising one.
• Believes that relevant information with the managers is far from complete.
• Managers take decisions for future on the basis of incomplete information.
• Management, realising the complexities of calculations, inevitable uncertainties of future,
and imperfections of the data that has to be employed for “Optimal decisions”, cannot help
but be satisfied with something less, illustrating the model of “Satisficing”. Here the
management aims at “satisfactory profits”. It is an aspiration for the Management based on
the past experiences and judgment about future uncertainty.
• Useful brainstorming is done through “Search Behaviour” to find reasons for the deviations
from “Aspiration level”.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 DEMAND ANALYSIS

Joel Dean comments on DEMAND ANALYSIS:

Demand Analysis seeks to search out and measure the forces that determine sales

Demand:
• Demand for a commodity refers to the quantity of the commodity which an individual
consumer or a household is willing to purchase per unit of time at a particular price.
• The definition for demand implies:
• Desire of the commodity to buy the product
• His willingness to buy the product
• Sufficient purchasing power in his possession to buy the product.

Individual and Household Demand

Demand arises from an individual.
• There are commodities which are generally demanded by individual consumers. E.g.
Cigarettes, footwear etc which are called as Individual Demand
• There are commodities which are demanded by households. E.g. Refrigerator, house
etc which are called as Household Demand.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 DETERMINANTS OF DEMAND

Determinants of Demand:
• An individuals demand for a commodity depends on the household’s Desire for the
commodity and to purchase it.
• The desire to purchase is revealed by Tastes and preferences of the individual /
households.
• The capability to purchase depends upon his Purchasing power (Income and Price
of the commodity).
• Since households purchase a number of commodity, their quantity depends upon the
price of that particular commodity and prices of other commodities.
All of the above are all called as explanatory variables and the quantity demanded of a
product by a consumer is called the explained variables.
The important determinants of demand are:
a. Price of the Commodity
b. Income of the Consumer
c. Price of Related goods
d. Tastes and Preferences.
e. Advertisement
f. Expectations
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 DETERMINANTS OF DEMAND
Price of the Commodity:
• A Consumer buys more of a commodity when its price declines and vice-versa.
• For any normal good the price of a commodity and its demand varies inversely other
factors remaining constant.
• A fall in the price of a normal good leads to rise in consumers purchasing power. He can
buy more of the product. This is called as Substitution Effect.
• An increase in price will reduce his purchasing power and thereby reducing demand for the
commodity. This is called as Income Effect.

Income of the Consumer (Refer Fig. 5.1 Pg No. 76):

• An increase in the income of the consumer will lead to increase in purchasing power of
consumer. He would buy more of a product that he had bought earlier.
• Here the extent of increase may differ between commodities.
• The shifts in the quantity demanded and income move in the same direction.
• Incase of commodities like foods, fruits and vegetables the quantity demanded increases
with an increase in income (beyond a period, the demand remains unchanged even with an
increase in income).
• There are cases where the quantity demanded decreases even with an increase in income
(Giffen Goods or Inferior Goods) – Negative or Exceptional Demand Curve.
Prepared by Mr. R. Sriram, Lecturer - MBA,
STC - Pollachi.
 DETERMINANTS OF DEMAND
Price of Related Goods:
• A change in price of one commodity influences the demand of the other commodity, then,
the two commodities are related.
• When price of one commodity and the quantity demanded of other commodity move in the
same direction the two are called as Substitutes (Goods that have essentially the same
use).
• When price of one commodity and the quantity demanded of the other commodity move in
opposite direction the two are called as Complements (Goods that are used together).

Tastes and Preferences:

• The change in tastes and preferences of a consumer in favour of a commodity results in
greater demand for a commodity and vice versa.

Advertisement:
• It is to influence the tastes and preference of consumers towards a product and increase
sales.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 DETERMINANTS OF DEMAND
Expectations:
• Expectations of are two types:
• Related to their future income: If the consumer expects a higher income in future, he
spends more at present and thereby the demand for goods increases and vice versa.
• Related to future price of the good and its related goods: If the consumer expects the
future prices of the goods to increase then he would rather like to buy the commodity
now than later. This would increase the demand for the commodity. The opposite
holds good when it is expected that prices in future will come down.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 DEMAND FUNCTION
Demand Function – Meaning:
A mathematical expression of the relationship between quantity demanded of the
commodity and its determinants is known as the demand function.
• When this relationship relates to the demand by an individual consumer it is known a
individual’s demand function.
• When it relates to the market it is called market demand function.

Mathematical Expression of Demand Function (Individual Demand):

QdX = f(Px, Y, P1….Pn-1, T, A, Ey, Ep, u)
QdX refers to the quantity demanded of product X
Px, refers to the price of the product X
Y refers to the level of household income
P1….Pn-1 refers to the prices of all the other related products in economy (related products
include substitutes and compliments)
T refers to the tastes of the consumers
A refers to the advertising
Ey refers to the expected future income
Ep refers to the expected future prices
u refers to all those determinants which are not covered in the above.
Prepared by Mr. R. Sriram, Lecturer - MBA,
STC - Pollachi.
 DEMAND FUNCTION
Mathematical Expression of Demand Function (Market Demand):
QdX = f(Px, Y, P1….Pn-1, T, A, Ey, Ep, P, D, u)
QdX refers to the quantity demanded of product X
Px, refers to the price of the product X
Y refers to the level of household income
P1….Pn-1 refers to the prices of all the other related products in economy (related products
include substitutes and compliments)
T refers to the tastes of the consumers
A refers to the advertising
Ey refers to the expected future income
Ep refers to the expected future prices
P refers to the population (size of the market)
D refers to the distribution of consumers in various categories depending on
income, age, sex etc.
u refers to all those determinants which are not covered in the above.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 LAW OF DEMAND

The Law of Demand:

The Law of Demand states that higher the price lower the quantity demanded and vice
versa, other things remaining constant. i.e., Qd = f(P) other things remaining same.

The Operating Procedure of Law of Demand

• Given the prices of the related goods, income and tastes and preferences of the consumer, if
prices of the good increases its quantity demanded decreases, while if price of the good
decreases its quantity demanded increases.
• The Law of Demand operates due to the underlying effects of substitution and real income
changes. (Substitution effect on price change & Income effect on Price change)
• Indifference Curve Analysis: In case of those goods where positive income effect is of a
lower magnitude than the negative substitution effect, the law of demand still holds good
even while those goods are “inferior”. It is only in the case of those inferior goods where
positive income is far from stronger than negative substitution effect that their combined
effect become positive. These are known as “Giffen Goods”.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 DEMAND SCHEDULE

The Demand Schedule:

A Demand schedule at any particular time refers to the series of quantities the
consumer is prepared to buy at its different prices.

10 Individual Dmd
Illustration: P
R
I
  Quantities demanded by Consumers Market C
(In Units) (Individual Demands) Demand E

Price A B C
1
10 1 0 3 4 QTY DEMANDED

9 3 1 6 10 10 Market Demand
8 7 2 9 18 P
R
I
7 11 4 12 27 C
E

6 13 6 14 33
4
QTY DEMANDED

The Demand schedule when represented diagrammatically is known as Demand Curve

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 LAW OF DEMAND
The Demand Curve:
The Demand Curve shows the maximum amount of goods which the consumer would be
willing to buy at each possible price of the goods, under given conditions of demand.
The individual demand curve shows the maximum price which an individual consumer or a
household would be prepared to pay for different amount of goods.

Why is the Demand Curve Sloping Downwards?

• When other things remaining constant, an individual will buy more of a commodity at a
lower price and less of that commodity at higher price.
• The reasons for a downward sloping demand curve are:
• The operation of the law of diminishing marginal utility. It states that as one goes on
consuming more and more units of a commodity, its utility to him goes on
diminishing. To get maximum satisfaction, a consumer buys a commodity in such ta
way that marginal utility of the commodity is equal to its price.
• A commodity tends to be put to more use when it becomes cheaper. Thus the existing
buyers purchase more and some new consumers enter the market. The cumulative
effect is thus, an extension of demand when price falls.
• A fall in the price of a superior good will lead to a rise in the consumer’s real income.
The consumer can therefore, buy more of it (Substitution Effect). When there is a
rise in price of a superior good will result in decline in consumers real income
(Income Effect), therefore, the consumer would buy less of the goods.
Prepared by Mr. R. Sriram, Lecturer - MBA,
STC - Pollachi.
 LAW OF DEMAND
Why is the Demand Curve Sloping Downwards? (Contd…)
• The use of the concept of Income effect and Substitution effect is the main reason for a
downward sloping demand curve.

Exceptions to the Law of Demand:

• Giffen Goods: If there is an inferior good in whose case the income effect is stronger than
the substitution effect, the law of demand would not hold. For Example, during Napoleon's
period when gold was not even found, people used Aluminum. Once we discovered Gold,
the use of aluminum became inferior. (The understanding here is when the price of
Aluminum becomes cheaper, you buy less of it and shift or compensate the purchasing
power to buy aluminum to other goods).
• Commodities which are used as status symbols: Some expensive commodities like
diamonds, BMW cars are used as status symbols to display one’s wealth. The more
expensive these commodities become, more will be their value as a status symbol and
hence greater will be their demand. (The amount demanded increases with an increase in
the price and decreases with a decrease in the price).
• Expectations of change in price of commodity: If a household expects the price of a
commodity to increase, he may start purchasing greater amount of commodity even at the
presently increased price (Substitution Effect). Similarly if a household expects the price
of the commodity to decrease, he may postpone his purchase (Income Effect).

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 LAW OF DEMAND
Expansion and Contraction of Demand:
Movement along a demand curve is caused by a change in the price of the commodity. This
change is called Extension and Contraction of Demand.

10 Contraction Extension
P
r
5
i
c
e
2
(
R
s
)
2 5 10

Change in Quantity (In Kgs)

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 REVENUE CONCEPTS
Revenue Concepts:
Revenue is closely related to demand. It is the sale proceeds of a firm (Price X Quantity) of
a good during a particular period of time.
• Total Revenue
• Average Revenue
• Marginal Revenue

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 TYPES OF DEMAND
Demand can be categorised into different types based on its nature. They are provided below:
Derived Demand and Autonomous Demand: Those inputs or commodities which are
demanded to help further production of commodities are said to have derived demand. For
e.g.. Raw Materials, Labour Machines etc. The Derived Demand is strictly determined by
the level of demand of the final goods in whose production these derived demand goods are
used. Autonomous Demand is the one where a commodity is demanded because it is
needed for direct consumption. For e.g.. Pieces of furniture, personal mode of transport.
• In specific cases of automobile commodities, both the derived and autonomous demand
remains the same. For e.g., the demand generated for the private car is an autonomous
demand that can also be a derived one if the same car is being used as a taxi.
• Autonomous demand is more price elastic than the derived demand.
• Forecasting the derived demand is easy when the proportion between two products (raw
materials) is fixed and stable.

Demand for Producers’ Goods and Consumers’ Goods: The difference in these two types of
demand are that consumers’ goods are needed for direct consumption, while the producers’
goods are needed for producing other goods (consumers’ goods or further producers’
goods). Soft drinks, milk, bread etc., are the examples of consumers’ goods, while the
various types of machines, steel, tools, etc., are some of the examples of producers’ goods.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 TYPES OF DEMAND
• Both Producers’ goods and Consumers’ goods can be categorised into two. They are (i)
durable and (ii) non-durable goods. The durable goods, are the ones which have repeated
uses. Non-durable goods are the ones which cannot be used more than once. Shoes, Ready
Made Garments, Residential House, Electrical and Electronic appliances etc., are examples
of durable consumers’ goods while Machinery, Tools, Industrial Buildings, Transportation
Equipments etc., are examples of durable producers’ goods.
• Distinctive Features of Durable Consumers’ Goods include:
– The demand for consumers’ durable occur at irregular intervals of time as compared
to the regular demand for consumers’ non-durable goods.
– Since the consumers’ durables are generally used several members of the family, the
demand for these products depends upon the needs and preferences of the family.
– Some of the durable consumers’ goods can be used only after the co-operating services
are available.
• Distinctive Features of Producers Goods include:
– Those who demand producers’ goods are professionals and they are conscious of the
price and quality of the goods and are also its sensitive to the availability of
substitutes.
– The buyers of the producers’ goods are not succumbed to pressure advertising but to
go by prices since their motives to buy are purely for economic and profit prospects.
– Since producers’ goods are of a derived type of demand, price fluctuations and
volatility is prevalent.
Prepared by Mr. R. Sriram, Lecturer - MBA,
STC - Pollachi.
 TYPES OF DEMAND
Demand for Durable Goods and Non-Durable Goods: Durable goods are the ones which can
be stored and whose replacement can be postponed. On the other hand, the non durable
goods are needed as a routine and their demand is therefore made largely to meet day to
day needs. Durable goods meet both the current as well as future demand, whereas non
durable goods meet only the current demand.
• In the case of non-durable goods, the demand ha simple relationship with price. Due to the
reason being the demand is current, it has got a direct demand where the law of demand
applies here. The goods of mass consumption falls into this category.
• Some of the non-durable goods include:
– Perishable goods (Fruits, Vegetables)
– Non-perishable goods (Pulses, Cereals, Sugar).
• Durable goods can be divided into two parts namely – demand for replacements and new
demand.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 TYPES OF DEMAND
Industry Demand and Firm Demand: The term Firm Demand denotes demand for a
particular product of a particular firm. When we add demand for a particular product
faced by all the companies producing that product, we get what is called an Industry
Demand. Industry Demand refers to the total demand for the product of a particular
industry.

• For a firm, the company demand (firm demand) is very important than that of an Industry
Demand. An entrepreneur should know how much does his company contribute towards
the industry demand.
• Every company operates in the market with different operating structures called as Market
Structure. The Market structure is generally classified based on two concepts.
– The Number of Sellers
– The Degree of Product Differentiation.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 TYPES OF DEMAND
Industry Demand and Firm Demand: The term Firm Demand denotes demand for a
particular product of a particular firm. When we add demand for a particular product
faced by all the companies producing that product, we get what is called an Industry
Demand. Industry Demand refers to the total demand for the product of a particular
industry.

• For a firm, the company demand (firm demand) is very important than that of an Industry
Demand. An entrepreneur should know how much does his company contribute towards
the industry demand.
• Every company operates in the market with different operating structures called as Market
Structure. The Market structure is generally classified based on two concepts.
– The Number of Sellers
– The Degree of Product Differentiation.

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 ELASTICITY OF DEMAND

Elasticity of Demand: The Elasticity of Demand (Ed) is defined as the percentage change in
quantity demanded caused by one percent change in demand determinant under consideration
while other determinants are held constant. It is represented by the following formulae:

Ed = Percentage Change in Quantity demanded of good X / Percentage change in

Determinant Z.

The Determinants of Demand (earlier studied) can be categorised and their individual elasticity
can be calculated by the following methods:
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Promotional Elasticity of Demand
5. Expectations Elasticity of Demand

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 ELASTICITY OF DEMAND - MEASUREMENTS

The Elasticity of demand can be measured in two methods:

1. Arc Elasticity of Demand
2. Point Elasticity of Demand

Point Elasticity of Demand: Point Elasticity of demand relates to the elasticity at a particular
point on the demand curve. This approach can be used to evaluate the effect of very small price
changes or to compute the price elasticity at a particular price.

Mathematically expressed:

Ep (Price Elasticity) = Change in Quantity demanded / Total Quantity Demanded

Change in Price of the Product / Price of Product
= Delta Qd / Qd
Delta P / P
= Delta Q * P / Delta P * Q

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.
 ELASTICITY OF DEMAND - MEASUREMENTS

Arc Elasticity: Arc Elasticity of demand is the average elasticity over a segment of the demand
curve. It is appropriate for analyzing the effect of discrete changes in price.

Mathematically expressed:

Ep = Q2 – Q1 / ((Q2+Q1) /2)
P2 – P1 / ((P2 + P1) / 2)
= (Q2 - Q1) / (P2 – P1) * (P2 –P1) / (Q2+Q1)

Prepared by Mr. R. Sriram, Lecturer - MBA,

STC - Pollachi.