Unit 1

Managerial Economics (Concept & Importance)

● "Economics is an enquiry into the nature and causes of wealth of nations."- Adam Smith.

● Economics is the study of scarcity and its implications for the use of resources, production of goods and services, growth
of production and welfare over time.

● Economics is the social science that studies the production, distribution, and consumption of goods and services.

Managerial Economics “Managerial economics is concerned with the application of economic principles and
methodologies to the decision-making process within the firm or organization. It seeks to establish rules and principles to
facilitate the attainment of the desired economic goals of management”-Evan J Douglas.

● Economics comprises of numerous concepts and theories.

● The application of these concepts and theories in the process of business decision making is known as managerial
economics.

● In other words, managerial economics is the study of different economic concepts used in business decision making.

Some of the popular definitions of managerial economics are given as follows:

● According to Mansfield, “Managerial economics is concerned with the application of economic concepts and economics
to the problems of formulating rational decision making.”

● “Managerial economics is the integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management” - Spencer

● “Managerial Economics refers to those aspects of economics and its tools of analysis most relevant to the firm’s business
decisions-making process. By definition, therefore, its scope does not extend to macroeconomic theory and the economics
of public policy an understanding of which is also essential for the manager.” - Haynes, Mote, and Paul

● From the above definitions, it can be said that managerial economics is a link between the two disciplines, namely
management and economics.

● Therefore, it can be said that managerial economics is a special discipline of economics that can be applied in business
decision making of organizations.

● Managerial economics deals with the analysis of economic theories and laws to take decisions based on rational thinking.
Figure below shows the application of economics in business decision-making:

Scope of Managerial Economics:

● The two branches of economics, which are macroeconomics and microeconomics, can be directly or indirectly applied to
the business decision making of an organization depending on the purpose of analysis.

● Managerial economics undertakes both macroeconomics (industry) and microeconomics (firm) theories. It involves the
application of different economic tools, theories, and methodologies for analysing business problems and decision making.

● What is PESTLE?

● A PESTLE analysis studies the key external factors

○ Political ○ Economic ○ Sociological ○ Technological ○ Legal ○ Environmental

1
● that influence an organisation. ‘

Majority of the business problems can be related to

○ Demand ○ Supply ○ Level of production (Batch / Mass / Job) ○ Pricing ○ Market structure, and ○ Extent of competition

● The areas of business problems to which economic tools and theories can be directly applied are classified into two
categories, which are

○ microeconomics applied to operational or internal issues, and ○ macroeconomics applied to environmental or external
issues

Application of Microeconomics:

● In business decision making, microeconomics can be applied to deal with operational issues, which are internal to an
organization. These issues are under the control of management and can be solved by taking appropriate decisions.

● An organization has to deal with internal issues like type of business and product, product categories, size of organization,
size of the team, technology to be used, price determination, promotional decisions, investment decisions, and
management of inventory. Microeconomics helps in solving these issues, which are generally faced by business
organizations.

Below microeconomic theories are used to address various operational issues:

Demand Theory:

● Demand theory describes the way that changes in the quantity of a good or service demanded by consumers affects its
price in the market. The theory states that the higher the price of a product is, all else equal, the less of it will be
demanded, inferring a downward sloping demand curve.

● Where Demand is defined as the quantity of good and services that customers are willing and able to purchase during a
specified period under a given set of economic conditions.

Demand Theory is applied to understand the buying behavior of consumers. This theory helps managers to determine the
factors that affect the buying decisions of consumers and their needs and requirements. Demand theory helps businesses
to answer the following questions:

● Why does a consumer stop consumption of a good/service?

● How do customers react to changes in price, tastes and preferences, and income levels?

Therefore demand theory is helpful in deciding the type of product to be produced, determining the level of production,
and making pricing decisions in the present market conditions.

2
Production Theory:

● Production theory explains the relationship between input and output. It mainly deals with the issues related to
production. It explains the changes in the cost of a product or service and the effect on the total output with change in a
particular factor (input) while keeping the other factors at constant.

● Apart from this, the production theory deals with maximization of output (when the resources are limited) and
determination of optimum size of output. Therefore it helps managers to decide the quantum of output (minimum and
maximum), labor and capital to be employed, and total output.

Price Theory:

● Price theory is another microeconomic principle that uses the concept of supply and demand to determine the
appropriate price point for a given good or service. The concept of price theory allows for price adjustments as market
conditions change.

● Price theory helps in determining the price of a product or service under different market conditions. Price theory is
concerned with the analysis of market structure and determination of price. It also enables businesses to determine the
favourable and unfavourable conditions for price discrimination and how promotion would help in increasing sales.
Therefore, the price theory and market analysis helps in finalizing the pricing policies of an organization.

Profit Theory:

● In a certain production process, if an entrepreneur uses land, labour and capital owned by his own self, then the residual
part of his revenue, after payment is made to all these factors of production, is profit.

● This theory helps organizations to measure the return on capital and total resources applied. Since the main objective of
any organization is to earn profit, an organization does not always earn the same amount of profit every time due to
uncertainties in business.

● Therefore, managing profit of an organization helps in minimizing the risk factor and predicting the actual profit for
future.

Capital Theory:

● Enables managers to make wise capital and investment decisions.

● Capital is a scarce resource of any organization; therefore, it should be allocated efficiently.

● Generally, managers, while managing capital, face issues related to the selection of investment project and efficient
allocation of capital.

● These issues are dealt with the help of the capital theory. The capital theory helps managers in investment decision
making, selecting appropriate projects, and capital budgeting.

Application of Macroeconomics:

● Macroeconomic deals with issues related to the general business environment in which an organization operates.

● The environmental issues can be associated with the economic, political, and social environment of a country. These are
uncontrollable external factors over which a business has almost no control

The economic environment comprises the following factors:

● Political system of the country

● Type of economic system in the country (open/closed/mixed)

● Government rules, regulations and policies

● Pattern of national income, employment, saving, and investment of the country

● The functioning of the financial sector of the country

● Structure and nature of foreign trade (imports & exports) in the country

● The trends of labor supply and capital market strength of the country

3
● The value system of society, customs, and habits

● The impact of other countries.

● As explained, it is not possible for an individual organization to deal with all these factors that constitute the Macro
environment of any country.

● However, organizations in a country, together stimulate its economic environment.

● All these factors have a significant impact on the functioning of individual organizations. Therefore, organizations, while
decision making, should take into consideration the economic, political, and social factors that constitute the economic
environment of a country.

Importance of Managerial Economics:

● The main economic objective of any business is profit maximization. To achieve this objective, an organization needs to
ensure the effectiveness of its decision making process.

● Decision-making is defined as a process of selecting the best course of action among the available alternatives, so that
the set business objectives can be achieved.

● A sound decision needs a perfect knowledge of various economic theories, concepts, and tools that are directly included
in the business decision making. Managerial economics enables businesses in effective business decision making.

It helps an organization in the following ways:

1. Apply different economic theories and tools to the real world business environment ○ in taking decisions related to type
of product, investment, pricing, and level of production

2. Enables managers to select optimum production techniques

3. Utilize various economic concepts, such as demand theory, production theory, and capital theory, which help in studying
and analyzing different business problems ○ in making future decisions with respect to economic variables, such as price,
demand, supply, and cost

4. Formulating business policies

○ in assessing relationship between different economic variables, such as demand, supply, income, employment, and profit

The flow of goods and services in the economy

4
Classification of Goods and Services

On the Basis of Use (final consumption or further processing) and Purchaser

● Final Goods __ a packet of cotton balls at a retail shop

○ Final Consumer Goods/Consumption Goods

■ Consumer Durables __ a car, a computer

■ Consumer Non-Durables __ fruits, vegetables, milk

■ Consumer Semi-Durables __ clothes, shoes, pen

■ Service __ doctor, teacher ○ Final Producer Goods/Capital Goods __ machinery

● Intermediate Goods __ log of wood Stock Variables

● A variable is said to be a stock variable, if it is measured at a particular point of time.

● Such variables do not have an element of time attached with them.

● For example, capital balance as on March 31, 2010. Flow variables

● A variable is said to be a flow variable, if it is measured over (during) a period of time.

● Since such variables are measured over a time interval, it can be said that they have an element of
time attached to them.

● For example, income earned during the month of March.

Circular Flow in an economy

We can classify the circular flows in an economy into the following two categories.

1. Real Flow/Product Flow

2. Money Flow/Income Flow A two-sector circular flow model

5
National Income (Concept, Types & Measures)
National Income (Dadabhai Naoroji estimated first national income in India)

● It can be defined as the total monetary value (money value) of all final goods and services produced by a country during
a period of one year.

● The essential condition is that only those goods and services were included which have market value (not factor value).

National Income - defined by marshal

“The labour and capital of a country, acting on its natural resources, produce annually a certain net aggregate of
commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the
country or national dividend.”

Why is national Income important?

● Setting up economic policies: It is an indicator of nation’s economy. This data is very useful in making economic policies.

● Budget Preparation : Budget of a country is highly dependent on national income. Income and expenditure planning for
the coming year is done by keeping into mind the National Income.

● Standard of living: Government can look at national income data to measure economic upliftment of a nation and per
capita income (National Income / Total Population).

● Identifying Inflation and Deflation gaps: National income helps the RBI to come up with effective monetary policies to
tackle inflation and deflation.

Que - What is better in an economy? Inflation or deflation?

Que - What is Phillips curve Phillips curve

(The inverse relationship between the unemployment rate and inflation)

Circular Flow in an economy

We can classify the circular flows in an economy into the following two categories.

1. Real Flow/Product Flow

2. Money Flow/Income Flow

6
7
Income Concepts used to measure national Income are

● GDP (Gross Domestic Product) ● NDP (Net Domestic Product) ● GNP (Gross National Product) ● NNP (Net National
Product)

Gross Domestic Product (GDP)

● It is the money value of all goods and services produced within the domestic territory of a country during one financial
year. These goods and services may be either consumer goods or capital goods. These may be produced in private sector as
well as government sectors or by a foreign entity. However, it does not include the value of intermediate goods and
services.

● The profits earned or losses incurred on account of changes in capital assets as a result of fluctuations in market prices,
are not included in the GDP, If they are not responsible for the current production of the year.

Q - Gross Domestic Product (GDP) will include:

● I shifted my production from small unit to big guns in a SEZ, would the change/profit/loss in capital assets be added ?

● I cook and ate 1 kg to kaju katli and gain weight, would that be added?

Calculation of GDP : GDP is calculated by considering only the market value of the goods and services. When any business
raises it's stocks of goods it is considered as its expense hence this production of stock or inventory will raise the GDP.

GDP calculation (expenditure approach) is done by adding the expenditures made by the three groups of users.

Accordingly, GDP is defined by the following formula:

GDP = Consumption (household) + Investment (by business) + Government Spending + Net Exports (Exports - Import) or
GDP = C + I + G + NX

8
Where Consumption (C) represents private-consumption expenditures by households and nonprofit organizations,

Investment (I) refers to business expenditures by businesses and home purchases by households,

Government spending (G) denotes expenditures on goods and services by the government and

Net exports (NX) represents a nation’s exports minus its imports.

The expenditure approach is so called because all three variables on the right-hand side of the equation denote
expenditures by different groups in the economy. The idea behind the expenditure approach is that the output that is
produced in an economy has to be consumed by final users, which are either households, businesses, or the government.
Therefore, the sum of all the expenditures by these different groups should equal total output—i.e. the GDP.

Types of GDP

● Basis on how the GDP is calculated GDP can be expressed as Real GDP or Nominal GDP.

● Real GDP tracks the total value of goods and services calculating the quantities but using constant prices (base year
concept) that are adjusted for inflation. This is opposed to nominal GDP that does not account for inflation.

● The main difference between nominal GDP and real GDP is the adjustment for inflation. Since nominal GDP is calculated
using current prices, it does not require any adjustments for inflation.

Why GDP measurement is important ?

● GDP is important because it gives information about the size of the economy and how an economy is performing.

● The growth rate of real GDP is often used as an indicator of the general health of the economy.

● In broad terms, an increase in real GDP is interpreted as a sign that the economy is doing well.

● Real GDP not Nominal GDP growth can be treated as an index of economic growth i.e. higher Real GDP implies higher
economic growth.

Net Domestic product (NDP)

The net domestic product equals the gross domestic product minus depreciation on a country's capital goods. Net
domestic product accounts for capital that has been consumed over the year in the form of housing, vehicle, or machinery
deterioration.

NDP = GDP-Depreciation on fixed capital

Net domestic product provides insight into the age or obsolescence of a country's assets, as well as how much the country
has to spend to maintain its current GDP.

* Remember that NDP is always less than GDP

Gross National Product (GNP)

Gross National Product (GNP) is the total value of all finished goods and services produced by a country's citizens in a given
financial year, irrespective of their location. GNP also measures the output generated by a country's businesses located
domestically or abroad.

What is the difference between GDP and GNP?

The basic distinction between GDP and GNP is the difference in estimating the production output by foreigners in a country
and by nationals outside of a country.

Calculation of GNP:

GNP = GDP + Net factor income from abroad

or

GNP = C + I + G + X + Z

9
Where C is Consumption, I is investment, G is government, X is net exports, and Z is net income earned by domestic
residents from overseas investments minus net income earned by foreign residents from domestic investments.

Why GNP calculation is important

Economists rely on the GNP data to solve national problems such as inflation and poverty. When calculating the amount of
income earned by a country's residents regardless of their location, GNP becomes a more reliable indicator than GDP.

While GDP is a measure of an economy's health, GNP tells us about a country's real income. GNP is the value of all the
income earned by a country's citizens and businesses, regardless of whether they are located in their own country or
abroad.

Net National Product (NNP) = GNP – Depreciation

NDP is a geographical concept, while NNP is a national concept.

NNP at Market price

It is the net value of the final value of goods and services evaluated at current market price in one year after deducting
depreciation on fixed capital.

NNP at factor cost (or National Income)

It is the sum total of all the income earned by factors of production such as wages, salaries, rents, profits and interests,
taxes, incomes of self-employed, etc.

Thus, NNP at market price is gross national product at market price minus depreciation. Net National Product at factor cost
is also called as national income. Net National Product at factor cost is equal to sum total of value added at factor cost or
net domestic product at factor cost and net factor income from abroad.

NNP at factor cost = NNP at market price – Indirect taxes + Subsidies

NNP at factor cost = (GNP at market price - Depreciation) – Indirect taxes + Subsidies

NNP at factor cost =National Income (NI)

One stop formulas:

● Gross = Net + Depreciation (Dep)

○ or Net = Gross – Depreciation

● National = Domestic + Net Factor Income from Abroad (NFYA)

○ Domestic = National – Net Factor Income from Abroad

● Market price = Factor cost + Net Indirect Taxes (NIT)

○ Factor cost = Market price – Net Indirect Taxes

● Net Indirect Taxes = Indirect Taxes – Subsidies

10
Private Income

Private income is either: any type of income received by a private individual or household, often derived from occupational
activities, or. income of an individual that is not in the form of a salary, wage, or commission (e.g. income from investments
or renting land or other property).

It is the income obtained by private individuals from any source, productive or otherwise and the retained income of
corporations.

Private income= (NNP at factor cost) + (Transfer payments) – (Deductions)

Private income= (NNP at factor cost) + (Transfer payments) – (Deductions)

● Transfer payments include pensions, unemployment allowances, sickness, maternity and other social security benefits,
gifts from abroad, windfall gains from lotteries and horse racing and interest on public debt.
● Deductions include income from government departments, surpluses of public undertakings, employee’s contributions
to the provident funds and life insurance etc.

Disposable Income

● Disposable income, also known as disposable personal income (DPI), is the amount of money that an individual or
household has to spend or save after income taxes have been deducted.

● It is that actual income which can be spent on consumption by individuals and families. The whole of the personal income
cannot be spent on consumption because a certain part of the personal income is to be paid for direct taxes.

Disposable income= personal income - direct taxes.

Per Capita Income

Per capita income (PCI) or average income measures the average income earned per person in a given area (city, region,
country, etc.) in a specified year. It is calculated by dividing the area's total income by its total population. Per capita income
is national income divided by population size.

This concept enables us to know the average income and the standard of living of the people. But it does not give a clear
picture of disposable income of common man as few nations have unequal distribution of national income with a wide gap
between poor and rich.

Methods of measuring national Income

Income arises out of the process of economic activity chain.

11
Production generates income; Income causes spending on goods and services; Spending in turn induces production.
Accordingly there are three ways in which we can measure the size of the income.

● By measuring the value of output produced – Product approach

● By measuring income earned by factors – Income approach

● By measuring the size of total expenditure – Expenditure approach

Thus, we can look at the national income as a flow of goods and services, a flow of income or a flow of expenditure.

Product approach/Output method/Value addition approach

Total value of final goods and services produced in a country during a year is calculated at market prices to arrive at GDP at
market price. Production from agriculture, forests, minerals from mines, goods produced by industries, contributions to
productions made by transport, communications, insurance companies, lawyers, doctors, teachers, hotels, entertainment,
fisheries etc are collected and assessed at current market prices. Then, depreciation is deducted to arrive at NDP at Factor
cost. Only the final goods and services are included and the intermediary goods and services, illegal productive activities
are left out.

NNP at factor cost = NNP at market price – Indirect taxes + Subsidies

Income Method

Production of goods and services is an outcome of combined efforts of various factors of production like land, labour,
capital and enterprise. Those factors get rewarded in form of wage, rent, interest, profit. Total income received by all the
factors of production in an economy during a certain period is called factor income.

These factor incomes were classified into three broad categories.

● Wage income/Labour income : received by employees either in cash or kind.

● Capital Income/Non-Wage income : Income paid to factors of production, in form of interest on capital, rent on building,
dividends, undistributed profit, interest on savings, bonus, royalties and profits of government enterprises.

● Mixed/Other Income : earnings like direct taxes collected by government, net factor income from abroad, value of
production for self consumption.

National Income = wage income + capital income + other income

Expenditure Method

It is based on the assumption that the income generated in an economy can be disposed either on consumption of goods
and services or in investment. Thus, national income equals national expenditure.

Components of final expenditure are

● Private consumption Consumption of durable and non – durable consumer goods, utility services done by public.

● Private investment Investment on capital goods like machines, plant setup, inventories, plots, houses.

● Government consumption Expenditure on compensation of employees, social benefits like pension, unemployment
allowance, etc.

● Government investment Construction of dams, bridges, machines, transport vehicles, power plants, etc.

● Net foreign investment all exports of merchandise and services minus all these imports in a year.

Thus, expenditure methods takes into account expenditure by household, business houses and government institutions to
determine the national income. Household sectors includes individuals, all non-government, non corporate enterprises like
sole proprietorship firms, partnerships and non – profit institutions.

12
Inflation (Concept, Types & Measurement)

What is Inflation?

In economics, inflation is a general rise (not specific commodity) in the price level of an economy over a period of time.
When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a
reduction in the purchasing power per unit of money. The opposite of inflation is deflation, a sustained decrease in the
general price level of goods and services.

❏ Inflation is a situation of rising prices in the economy.

❏ A more exact definition of inflation is a sustained increase in the general price level in an economy. Inflation means an
increase in the cost of living as the price of goods and services rise.

❏ The rate of inflation measures the annual percentage change in the general price level.

❏ Inflation leads to a decline in the value of money. “Inflation means that your money won’t buy as much today as you
could yesterday.”

❏ If the prices of goods rise. the same amount of money will purchase a smaller quantity of goods.

Causes of Inflation

❏ Increase in demand – aggregate demand growing faster than aggregate supply (growth too rapid)

❏ Higher production costs – For example, higher raw material prices resulting into higher costs

❏ Devaluation - controllable devaluation (not uncontrollable depreciation) leads to a decline in the value of a currency
making exports more competitive and imports more expensive. Generally, a devaluation is likely to contribute to
inflationary pressures because of higher import prices and rising demand for exports

❏ Money supply - Increasing the money supply faster than the growth in real output will cause inflation. The reason is that
there is more money chasing the same number of goods

❏ Rising wages – higher wages increase firm’s costs and increase consumers’ disposable income to spend more

❏ Printing excessive currency -Money becomes worthless if too much is printed. If the Money Supply increases faster than
real output then, ceteris paribus, inflation will occur. If you print more money, the amount of goods doesn't change. If there
is more money chasing the same amount of goods, firms will just put up prices

❏ Expectations of inflation – causes workers to demand wage increases and firms to push up prices

Types of Inflation (based on cause)

❏ Demand-pull Inflation: It occurs when the demand for goods or services is higher when compared to the production
capacity. The difference between demand and supply (shortage) result in price appreciation.

❏ Cost-push Inflation: It occurs when the cost of production increases. Increase in prices of the inputs (labour, raw
materials, etc.) increases the price of the product.

13
❏ Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A rise in prices results in higher wages to
afford the increased cost of living. Therefore, high wages result in increased cost of production, which in turn has an impact
on product pricing. The circle hence continues (inflation spiral)

Types of Inflation (based on rate of inflation)

❏ There are four main types of inflation, categorized by their speed.

❏ Creeping inflation – low, but consistently creeping up [2-3%].

❏ Walking/moderate inflation (3-10%)

❏ Running or Galloping inflation (10-49%)

❏ Hyperinflation (50%) Types of Inflation (based on rate of inflation)

❏ Creeping Inflation or mild inflation: When the rate of inflation slowly increases over time. For example, the inflation rate
rises from 2% to 3%, to 4% a year. Creeping inflation may not be immediately noticeable, but if the creeping rate of inflation
continues, it can become an increasing problem.

❏ Walking Inflation or moderate inflation: When inflation is in single digits – less than 10%. At this rate – inflation is not a
major problem, but when it rises over 4%, Central Banks will be increasingly concerned. Walking inflation may simply be
referred to as moderate inflation.

❏ Running inflation: When inflation starts to rise at a significant rate. It is usually defined as a rate between 10% and 20% a
year. At this rate, inflation is imposing significant costs on the economy and could easily start to creep higher.

❏ Galloping Inflation: This is an inflation rate of between 20% up to 1000%. At this rapid rate of price increases, inflation is
a serious problem and will be challenging to bring under control. Some definitions of galloping inflation may be between
20% and 100%. There is no universally agreed definition, but hyperinflation usually implies over 1,000% a year.

❏ Hyperinflation: This is reserved for extreme forms of inflation – usually over 1,000% though there is no specific
definition. Hyperinflation usually involves prices changing so fast that it becomes a daily occurrence, and under
hyperinflation, the value of money will rapidly decline.

Inflation Related Concepts

❏ Stagflation or inflationary recession: Stagflation (not stagnation) is characterized by slow economic growth and relatively
high unemployment—or economic stagnation—which is at the same time accompanied by rising prices (i.e. inflation).
Stagflation can also be alternatively defined as a period of inflation combined with a decline in gross domestic product
(GDP).

❏ Deflation: a fall in general prices – a negative inflation rate. ❏ Disinflation: a fall in the inflation rate. It means prices are
increasing at a slower rate. disinflation is when the inflation rate is falling from say 5% to 3%.

14
How is Inflation measured?

Inflation can be measured mainly by two methods

1. Price Index Methods

2. Gross National Product (GNP) deflator method

Price Index methods

A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some
base-year. To construct a price index we start by selecting a base year. Then we take a representative sample of goods and
services and calculate their value in the base year and current prices.

To measure inflation various Price indexes can be measured, major ones are mentioned below.

(a) Consumer Price Index (CPI):

A consumer price index measures changes in the price level of a weighted average market basket of consumer goods
and services purchased by households. A CPI is a statistical estimate constructed using the prices of a sample of
representative items whose prices are collected periodically. Consumer Price Index in India is published monthly by the
Central Statistical Organization (CSO). Consumer Price Indices (CPI) measure changes over time in the general level of
prices of goods and services that households acquire for consumption. CPI is calculated for a fixed list of items
including food, housing, apparel, transportation, electronics, medical care, education, etc. Recently, the Ministry of
Labour and Employment released the new series of Consumer Price Index for Industrial Worker (CPI-IW) with base
year 2016.

15
 (b) Wholesale Price Index (WPI):

Refers to the price index that is used to estimate the average change in price of goods in the wholesale market. The
Wholesale Price Index is the price of a representative basket of wholesale goods. In India earlier, WPI changes were used as
a central measure of inflation. But now India has adopted a new CPI to measure inflation.

The WPI measures the price of a representative basket of wholesale goods. In India, wholesale price index is divided into
three groups: Fuel and Power, Primary Articles and Manufactured Products.

Wholesale price indexes (WPIs) are reported monthly in order to show the average price changes of goods. The WPI is
published by the Economic Adviser in the Ministry of Commerce and Industry.

Base year for calculating WPI is 2011-12 is effective from April 2017.

Major components of WPI (all goods, no services)

❏ Primary articles is a major component of WPI, further subdivided into Food Articles and Non-Food Articles.

❏ Food Articles include items such as Cereals, Paddy, Wheat, Pulses, Vegetables, Fruits, Milk, Eggs, Meat & Fish, etc.

❏ Non-Food Articles include Oil Seeds, Minerals and Crude Petroleum

❏ The next major basket in WPI is Fuel & Power, which tracks price movements in Petrol, Diesel and LPG

❏ The biggest basket is Manufactured Goods. It spans across a variety of manufactured products such as Textiles, Apparels,
Paper, Chemicals, Plastic, Cement, Metals, and more.

❏ Manufactured Goods basket also includes manufactured food products such as Sugar, Tobacco Products, Vegetable and
Animal Oils, and Fats.

(c) Cost of living index (CLI) :

● The cost of living is the amount of money needed to cover basic expenses such as housing, food, taxes, and healthcare in
a certain place and time period.

● The cost of living is often used to compare how expensive it is to live in one city versus another.

● A cost-of-living index is a theoretical price index that measures relative cost of living over time or regions.

● It is an index that measures differences in the price of goods and services, and allows for substitutions with other items as
prices vary.

(d) Consumer food price index (CFPI) :

● Measurement of food price movement is important to assess the changes in food prices as well as its impact on the
general price level.

● Inflation in India is caused mostly by supply disturbances led by food items.

16
● There are two indices for measuring food inflation. ○ Food Price Index (FPI) calculated from food items that comes under
the WPI, and ○ Consumer Food Price Index (CFPI) by CSO

(e) Capital Goods Price Index (CGPI): The Capital Goods Price Index (CGPI) is a statistic that monitors changes in the prices
of fixed assets, as well as how changes in income affect changes in prices of these assets.

(f) Index for Industrial Production (IIP):

● The Index of Industrial Production (IIP) is an index which shows the growth rates in different industry groups of the
economy in a stipulated period of time.

● The IIP index is computed and published by the Central Statistical Organisation (CSO) on a monthly basis.

● Although IIP is not a direct indicator for inflation. Its main purpose is to provide a measure of the short term changes in
the volume of industrial production over a given reference period.

● The IIP figures are generally seen as an important but short-term indicator of whether industrial activity in a country has
risen or dipped.

GNP Deflator method

● The GNP deflator is simply the adjustment for inflation that is made to nominal GNP to produce real GNP.

● The gross national product deflator is an economic metric that accounts for the effects of inflation in the current year's
GNP by converting its output to a level relative to a base period.

● The GNP deflator provides an alternative to the Consumer Price Index (CPI) and can be used in conjunction with it to
analyze some changes in trade flows and the effects on the welfare of people within a relatively open market country.

The GNP deflator is calculated with the following formula:

GNP Deflator = (Nominal GNP/Real GNP) X 100

The result is expressed as a percentage, usually with three decimal places. Remember

❏ The higher the GNP deflator, the higher the rate of inflation for the period.

❏ The GNP deflator can be confused with the more commonly used gross domestic product (GDP) deflator. The GDP
deflator uses the same equation as the GNP deflator, but with nominal and real GDP rather than GNP.

Demand Analysis Utility Analysis & Indifference curves

What is Utility ?

Utility is a term in economics that refers to the total satisfaction received from consuming a good or service. The economic
utility of a good or service is important to understand, because it directly influences the demand, and therefore price, of
that good or service.

An example would be a consumer purchasing a vada-pao to eliminate hunger and to enjoy a tasty meal, providing him/her
with some utility.

❏ Utility can be defined as the power of a commodity that can satisfy a want. It is subjective in nature and depends on the
mindset of the customer.

❏ Utility does not necessarily mean usefulness. Utility is the ability of a good to satisfy a want. So a good that might satisfy
a particular want, might not be useful for a consumer. For example, alcohol provides utility but it is not useful as it harmful.

❏ Utility can vary at different time periods. A commodity might be useful today but might not be useful a few days later.
Utility is the basis for demand of a commodity by an individual, as the decision whether to purchase a commodity or not
depends on its utility.

❏ Utility of a commodity is its want-satisfying capacity. The more the need of a commodity or the stronger the desire to
have it, the greater is the utility derived from the commodity.

17
Utility has following two components

1. Product utility: it satisfies the requirements of a consumer

2. Consumers utility: is the psychological feeling of pleasure from its consumption to the consumer. It is a post-
consumption phenomenon.

Cardinal Utility Analysis

● Classical economists like Carl Menger Jeremy, Jeremy Bentham, Leon Walras and neo-classical economists like Alfred
Marshall believed that utility can be measured in quantitative figures just as height and weight. It gives absolute figures of
utility.

● Neo-classical economics coined the term ‘util’ to measure the utility of any good consumed. Thus ‘util’ is a unit of utility.
One util = to 1 unit of money and the utility of money remains constant.

Assumptions of cardinal utility theory.

❏ It is assumed that the consumer is rational in nature and he will spend his money on the commodity first which yields
the highest utility and last on which yields the least utility.

❏ Utilities derived from different commodities are independent of each other.

❏ A consumer has limited money to spend on goods.

❏ Consumer tries to maximize satisfaction on spending

❏ it is assumed that the utility gained from the successive units of a commodity consumed, decreases as a person
consumes more of them

❏ Marginal utility of money remains constant, whatever be the level of the consumer income

Limitations of cardinal utility theory

❏ Utility is not quantifiable

❏ Money is not the perfect measure of utility as its marginal utility is not constant

❏ It does not study price effect, substitution effect and income effect

❏ It cannot explain the behavior of demand for goods that cannot be divided.

Cardinal utility analysis assumes that level of utility can be expressed in numbers. For example, we can measure the utility
derived from an Ice cream and say, this ice cream gives me 50 units of utility.

Measures of Utility : utility can be measured as marginal Utility, Total Utility and Average utility.

Marginal Utility (MU)

Marginal utility is the added satisfaction a consumer gets from having one more unit of a good or service. The concept of
marginal utility is used by economists to determine how much of an item consumers are willing to purchase. ... Marginal
utility can be positive, zero, or negative.

MU(x) = TU(x) – TU(x – 1) = The Marginal Utility gained from the xth unit of consumption is equal to the difference between
the total utility gained from x units of consumption and the total utility gained from x–1 units of consumption.

18
1. Positive marginal utility. This is when there is a positive rate of change in the total utility between unit amounts.

2. Zero marginal utility. This is when there is no rate of change in the total utility between unit amounts.

3. Negative marginal utility. This is when there is a negative rate of change in the total utility between unit amounts.

Total Utility (TU)

Total utility is the summation of the utilities derived by a customer from the various units of a good at a point or over a
period of time. In the above table the second column depicts the change in total utility with every additional
consumption of quantity.

TU n = MU1 + MU2 + MU3 + ……..+ MU n = ∑MU

Average Utility Average utility is calculated by dividing total utility derived by the quantity of units of the commodity.

AU=TU/Q

AU = Average Utility

TU = Total utility

Q = Quantity

❏ TU increases with an increase in consumption of a commodity as long as MU is positive.

❏ In this phase, TU increases but a diminishing rate as MU from each successive unit tends to diminish.

❏ When consumption is increased beyond the point of satiety, TU starts falling as MU becomes negative.

❏ Point of satiety (satisfaction) is reached when MU=0.

Law of Diminishing Marginal utility

19
● It is also called Gossen’s first law, proposed by Hermann Heinrich in 1854. It states that the Marginal Utility (MU) of a
good diminishes as an individual consumes more and more units of a good.

● The extra utility or satisfaction that he derives from an extra unit consumed goes on decreasing. The law propounds
that, “ marginal utility from consuming each additional unit of a commodity declines as its consumption increases,
while keeping consumption of other commodities constant”.

● It is only the MU that declines and not the total utility TU

Assumptions of law of diminishing marginal utility

❏ Units of the commodity should be consumed continuously in succession at one particular time

❏ There should not be any changes in the taste, fashions, lifestyles, customs of the consumer, mental state should be
same

❏ The consumer is rational all units of commodity should be homogeneous in nature

❏ The consumption process is continuous

❏ Prices of all the units of commodity and their substitutes should remain the same Limitations of diminishing
marginal utility

❏ It is not applicable on goods that satisfy different wants because, after consuming a few units of if for satisfying a
want, the consumer can still consume more units and marginal utility does not fall.

❏ It does not apply for rare collections as utility increases when more and more units are collected.

❏ The law does not hold true when there is a change in the availability of complementary and substitute goods.

Law of Equi Marginal Utility

MUX /PX and MUY /PY are equal to 6 when 5 units of X and 3 units of Y are purchased. At this,, the consumer spends
his entire money income of Rs. 35 (= Rs. 4 x 5 + Rs. 5 x 3) and, thus, gets maximum satisfaction [10 + 9 + 8 + 7 + 6] + [11
+ 10 + 6] = 67 units. Purchase of any other combination other than this involves lower volume of satisfaction.

Law of Equi Marginal Utility

It is also known as the law of substitutions, law of maximum satisfaction and Gossen’s Second Law. This law is based on
the principle of obtaining maximum satisfaction from a limited income. It explains the behavior of a consumer when
he consumes more than one commodity.

The law states that a consumer should spend his limited income on different commodities in such a way that the last
rupee spent on each commodity yield him equal marginal utility in order to get maximum satisfaction.

Suppose there are different commodities like A, B, …, N. A consumer will get the maximum satisfaction in the case of
equilibrium i.e.,

MUA / PA = MUB / PB = … = MUN / PN

Where MU’s are the marginal utilities for the commodities and P’s are the prices of the commodities.

Assumptions of the Law

❏ There is no change in the price of the goods or services.

❏ The consumer has a fixed income.

20
❏ The marginal utility of money is constant.

❏ A consumer has perfect knowledge of utility.

❏ Consumer tries to have maximum satisfaction.

❏ The utility is measurable in cardinal terms.

❏ There are substitutes for goods.

❏ A consumer has many wants.

Limitation of the Law

There are some limitations to this law. They are

❏ The law is not applicable in case of knowledge. Reading books provides more knowledge and has more utility.

❏ This law is not applicable in case of fashion and customs.

❏ This law is not applicable for very low income.

❏ There is no measurement of utility.

❏ Not all consumer care for variety.

❏ The law fails when there are no choices available for the good.

❏ The law fails in case of frequent price change.

Importance of the Law

❏ This law is helpful in the field of production. A producer has limited resources and tries to get maximum profit.

❏ This law is helpful in the field of exchange. The exchange is of anything like some goods, wealth, trade, import, and
export.

❏ The law is useful for workers in allocating the time between work and rest.

❏ It is useful in case of saving and spending.

❏ It is useful to look for substitution in case of price rise.

Ordinal Utility Analysis

Cardinal utility analysis is simple to understand, but suffers from a major drawback in the form of quantification of
utility in numbers. In real life, we never express utility in the form of numbers. At the most, we can rank various
alternative combinations in terms of having more or less utility. In other words, the consumer does not measure utility
in numbers, though she often ranks various consumption bundles.

Assumptions of Ordinal Utility

Rationality: It is assumed that the consumer is rational who aims at maximizing his level of satisfaction for given
income and prices of goods and services, which he wish to consume.

Ordinal Utility: The indifference curve assumes that the utility can only be expressed ordinally. This means the
consumer can only tell his order of preference for the given goods and services.

Transitivity and Consistency of Choice: The consumer’s choice is expected to be either transitive or consistent. The
transitivity of choice means, if the consumer prefers commodity X to Y and Y to Z, then he must prefer commodity X to
Z. In other words, if X= Y, Y = Z, then he must treat X=Z. The consistency of choice means that if a consumer prefers
commodity X to Y at one point of time, he will not prefer commodity Y to X in another period or even will not consider
them as equal.

Non Satiety: It is assumed that the consumer has not reached the saturation point of any commodity and hence, he
prefers larger quantities of all commodities. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution refers to the rate at which the consumer is ready to substitute one commodity (A) for another commodity

21
(B) in such a way that his total satisfaction remains unchanged. The MRS is denoted as DB/DA. The ordinal approach
assumes that DB/DA goes on diminishing if the consumer continues to substitute A for B.

Limitations of ordinal utility

❏ The approach presumes that the consumers know about their preferences schedule, which is not always possible,
as the preferences keep changing.

❏ Analysis is limited to only two commodities

❏ The approach assumes that commodities are perfectly divisible.

❏ It does not explain the behavior of a consumer under uncertainty and risk.

Indifference Curve.

Definition: An indifference curve is a graph showing combination of two goods that give the consumer equal
satisfaction and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two
and all points give him the same utility. The main use of indifference curves is in the representation of potentially
observable demand patterns for individual consumers over commodity bundles.

The theory of indifference curves was developed by Francis Ysidro Edgeworth, who explained in his 1881 book the
mathematics needed for their drawing; later on, Vilfredo Pareto was the first author to actually draw these curves, in
his 1906 book.

Indifference schedule

It is a list of various combinations of two goods arranged in a manner, in which the customer is indifferent to them.
Suppose there are five combinations of good X (Biscuits) & good Y (Banana) consumed giving equal utility U. All the
combinations lying on this curve will give the same utility U.

Indifference map

● It is a graphical representation giving combinations of indifference curves.

● Consumers can take many other combinations giving total utility greater than or less than U. So there can be various
indifference curves showing various levels of total utility. In the below charts different indifference curves I1 , I2 , I3
make an indifference map. I1 want having lowest total utility U1 and curve I3 represents a combination giving the
highest total utility U3 .

● indifference curves can have various shapes shown below.

Convex to origin : this occurs in normal preferences and most of the indifference curves follow this shape.

22
Perfect substitutes : when the two commodities can be perfectly substituted for each other then the indifference
curve is negatively sloped straight line. In the below figure, the Consumer’s focus is only about getting total number of
goods i.e(X + Y). He is least concerned with whether he would get more of X or Y, hence indifference curve is a straight
line which leads to a situation of monomania where a consumer may spend all his income on one good, thus it gives a
corner solutions that is X or Y or both.

Figure 2 :Three indifference curves where Goods X and Y are perfect substitutes. The gray line perpendicular to all
curves indicates the curves are mutually parallel.

If two goods are perfect substitutes, then the indifference curves will have a constant slope since the consumer would
be willing to switch between at a fixed ratio. The marginal rate of substitution between perfect substitutes is likewise
constant.

Perfect complements : complementary goods are required to be consumed together which shows one Good Y cannot
be consumed without other Good X. Hence, indifference curves for complementary goods are of the shape of a right
angle, because there is no possibility of substitution.

Figure 3: Indifference curves for perfect complements X and Y. The elbows of the curves are collinear.

If two goods are perfect complements then the indifference curves will be L-shaped. Examples of perfect complements
include left shoes compared to right shoes: the consumer is no better off having several right shoes if she has only one
left shoe - additional right shoes have zero marginal utility without more left shoes, so bundles of goods differing only
in the number of right shoes they include - however many - are equally preferred. The marginal rate of substitution is
either zero or infinite.

Properties of Indifference curves

Properties of indifference curves are:

(1) Indifference curves can never cross.

(2) The farther out an indifference curve lies, the higher the utility it indicates.

(3) Indifference curves always slope downwards.

23
(4) Indifference curves are convex.

(5) upper indifference curves represent a higher level of satisfaction than the lower ones

(6) Marginal rate of substitution (MRS) is negative and goes on decreasing. This diminishing marginal rate of
substitution causes the indifference curves to be convex to the origin. It also implies that no two commodities are
perfect substitutes for one another.

Demand Analysis Demand Elasticity and Demand Forecasting

Demand ? ❏ Wish / Desire / Need + ❏ Purchasing Power + ❏ Willingness to pay

Demand

● Demand is an economic principle referring to a consumer's desire to purchase goods and services and willingness to
pay a price for a specific good or service. Holding all other factors constant, an increase in the price of a good or
service will decrease the quantity demanded, and vice versa.

● Demand is made up of desire to buy something, willingness to pay for it and the ability to pay its price. This is
individual demand. Thus, demand is a function of price. Demand is significantly different from a need or a want or
wish to buy.

Law of Demand

The law of demand states that other factors being constant (ceteris paribus), price and quantity demand of any good
and service are inversely related to each other. When the price of a product increases, the demand for the same
product will fall.

24
Exceptions to the law of demand Giffen goods:

● Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that are inferior in
comparison to luxury goods.

● However, the unique characteristic of Giffen goods is that as its price increases, the demand also increases. And this
feature is what makes it an exception to the law of demand.

● Cheaper varieties of goods like bajra, potatoes, salt etc. comes under giffen goods. So, rise in price of these goods
does not change the demand for these goods.

Ignorance : many people consider highly priced commodity to be good quality

Emergencies: people buy more goods at higher prices fearing shortage of commodities

Bandwagon effect : the buyer imitates his relatives or neighbors irrespective of the price of the product.

Expectations about future prices : when the buyer expects prices to rise in future he purchases more quantity even at
a higher price.

Veblen goods : Veblen goods are typically high-quality goods that are made well, are exclusive, and are a status
symbol. Veblen goods are generally sought after by affluent/rich consumers who place a premium on the utility of the
good. Examples of Veblen goods include designer jewelry, yachts, and luxury cars.

Demand curve

it is a graphical representation of quantity demanded for a specific price level, for a commodity, at a time. It is
downward sloping for normal goods.

Types of demand

Individual demand : this is the demand by a single customer at an individual level Market demand: it is the sum of all
the individual demands for a commodity in the market

Industry demand : total demand for a commodity produced by all these firms constituting that industry is called the
industry demand, like demand for all kinds of cars

Short run demand : demand for goods over a short period of time like fashion goods or seasonal goods

25
Long run demand : refers to the demand which exists over a long period of time. For example demand for products like
FMCG have a long run demand

Latent demand : A consumer want that is unable to be satisfied, due to a lack of awareness about a suitable product’s
existence; lack of information about such a product’s advantages, or a lack of money

Autonomous demand : also called as directive demand, is one that arises on its own out of a natural desire to
purchase. The demand for food, shelter, clothes, and vehicles is autonomous as it arises due to biological, physical, and
other personal needs of consumers.

Derived demand : it arises because of the demand for some other commodity, like demand for house is autonomous
demand. Demand for cement, bricks, steel bars is derived demand, derived from the construction needs.

Demand for durable goods : goods whose usefulness is not exhausted in a single day or single use.

Demand for nondurable goods : nondurable goods are those which can be consumed only once in a very short time.
Food items fall in this category. These goods are also perishable in nature.

Demand Curve is downward sloping, why?

1. Law of Diminishing Marginal Utility

2. Income effect - fall in the purchasing power of the money

3. Substitution effect - relatively cheaper substitute goods

Shift in Demand and Movement along Demand Curve

● A shift in demand means at the same price, consumers wish to buy more.

● A movement along the demand curve occurs following a change in price.

Movement along the demand curve

A change in price causes a movement along the demand curve. It can either be contraction (less demand) or
expansion/extension (more demand)

26
A shift in the demand curve occurs when the whole demand curve moves to the right or left. For example, an increase
in income would mean people can afford to buy more widgets even at the same price.

The demand curve could shift to the right for the following reasons:

❏ The good became more popular (e.g. fashion changes or successful advertising campaign)

❏ The price of a substitute good increases

❏ The price of a complement good decreased

❏ A rise in incomes

❏ Seasonal factors

Demand function

Demand function represents the relationship between

● D x - the quantity demanded for a commodity (dependent variable) and

● P x - the price of the commodity (independent variable)

Let us assume that the quantity demanded of a commodity X is Dx , which depends only on its price Px , while other
factors are constant. It can be mathematically represented as: D x = f (Px )

Short run demand function

Long run demand function

Linear demand function

In the linear demand function, the slope of the demand curve remains constant throughout its length.

27
Elasticity of Demand

Elasticity is a concept in economics that talks about the effect of change in one economic variable on the other.

Elasticity of Demand

Elasticity of Demand, or Demand Elasticity, is the measure of change in quantity demanded of a product in response to
a change in any of the market variables, like price, income etc. It measures the shift in demand when other economic
factors change.

In other words, the elasticity of demand is the percentage change in quantity demanded divided by the percentage
change in another economic variable.

The demand for a commodity is affected by different economic variables:

1. Price of the commodity

2. Price of related commodities

3. Income level of consumers

28
“The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded
increases much or little for a given fall in price, and diminishes much or little for a given rise in price”. – Alfred
Marshall, British Economist

3 Types of Elasticity of Demand

On the basis of different factors affecting the quantity demanded for a product, elasticity of demand is categorized into
mainly three categories:

● Price Elasticity of Demand

● Cross Elasticity of Demand

● Income Elasticity of Demand

Let us look at them in detail and their examples.

1. Price Elasticity of Demand

Any change in the price of a commodity, whether it’s a decrease or increase, affects the quantity demanded for a
product. For example, when there is a rise in the prices of ceiling fans, the quantity demanded goes down.

This measure of responsiveness of quantity demanded when there is a change in price is termed as the Price Elasticity
of Demand .

The mathematical formula given to calculate the Price Elasticity of Demand is: Price Elasticity of demand = % Change in
Quantity Demanded /% Change in Price

2. Income Elasticity of Demand

The income levels of consumers play an important role in the quantity demanded for a product. This can be
understood by looking at the difference in goods sold in the rural markets versus the goods sold in metro cities.

The Income Elasticity of Demand, refers to the sensitivity of quantity demanded for a certain good to a change in real
income (the income earned by an individual after accounting for inflation) of the consumers who buy this good,
keeping all other things constant.

The formula given to calculate the Income Elasticity of Demand is given as: Income elasticity of demand = % Change in
Quantity Demanded/% Change in Income

3. Cross Elasticity of Demand

29
In a market where there is an oligopoly, multiple players compete. Thus, the quantity demanded for a product does
not only depend on itself but rather, there is an effect even when prices of other goods change.

Cross Elasticity of Demand, is an economic concept that measures the sensitiveness of quantity demanded of one
good (X) when there is a change in the price of another good (Y), and that’s why it is also referred to as Cross-Price
Elasticity of Demand.

The formula given to calculate the Cross Elasticity of Demand is given as: Cross Elasticity of demand = (% Change in
Quantity Demanded for one good (X)) / (%Change in Price of another Good (Y))

5 other types of Elasticity of Demand

The effect of change in economic variables is not always the same on the quantity demanded for a product. The
demand for a product can be elastic, inelastic, or unitary, depending on the rate of change in the demand with respect
to the change in the price of a product.

On the basis of the amount of fluctuation shown in the quantity demanded of a good, it is termed as ‘elastic’,
‘inelastic’, and ‘unitary’.

❏ An elastic demand is one that shows a larger fluctuation in the quantity demanded of a product, in response to
even a little change in another economic variable. For example, if there is a hike of $0.5 in the price of a cup of coffee,
there are very high chances of a steep decline in the quantity demanded.

❏ An inelastic demand is one that shows a very little fluctuation in the quantity demanded with respect to a change in
another economic variable. An example of this can be petrol or diesel.

❏ Unitary elasticity is one in which the fluctuation in one variable and quantity demanded is equal

30
 1. Perfectly Elastic Demand

When there is a sharp rise or fall due to a change in the price of the commodity, it is said to be perfectly elastic demand.

In perfectly elastic demand, even a small rise in price can result in a fall in demand of the good to zero, whereas a small
decline in the price can increase the demand to infinity.

However, perfectly elastic demand is a total theoretical concept and doesn’t find a real application, unless the market is
perfectly competitive and the product is homogenous.

The degree of elasticity of demand helps to define the slope and shape of the demand curve. Therefore, we can determine
the elasticity of demand by looking at the slope of the demand curve.

A Flatter curve will represent a higher elastic demand. Thus, the slope of the demand curve for a perfectly elastic demand is
horizontal.

2. Perfectly Inelastic Demand (air or water)

A perfectly inelastic demand is the one in which there is no change measured against a price change.

Like perfectly elastic demand, the concept of perfectly inelastic is also a theoretical concept and doesn’t find a practical
application. However, the demand for necessity goods can be the closest example of perfectly inelastic demand.

The numerical value obtained from the PED formula comes out as zero for a perfectly inelastic demand.

The demand curve for a perfectly inelastic demand is a vertical line i.e. the slope of the curve is zero.

3. Relatively Elastic Demand

Relatively elastic demand refers to the demand when the proportionate change in the demand is greater than the
proportionate change in the price of the good. The numerical value of relatively elastic demand ranges between one to
infinity.

In relatively elastic demand, if the price of a good increases by 25% then the demand for the product will necessarily fall by
more than 25%.

31
Unlike the aforementioned types of demand, relatively elastic demand has a practical application as many goods respond in
the same manner when there is a price change.

4. Relatively Inelastic Demand

In a relatively inelastic demand, the proportionate change in the quantity demanded for a product is always less than the
proportionate change in the price.

For example, if the price of a good goes down by 10%, the proportionate change in its demand will not go beyond 9.9..%, if
it reaches 10% then it would be called unitary elastic demand.

The numerical value of relatively inelastic demand always comes out as less than 1 and the demand curve is rapidly sloping
for such type of demand.

5. Unitary Elastic Demand

When the proportionate change in the quantity demanded for a product is equal to the proportionate change in the price
of the commodity, it is said to be unitary elastic demand.

The numerical value for unitary elastic demand is equal to 1.

Factors Affecting Elasticity of Demand

❏ Nature of commodity. If the commodity is a necessity, then the demand is inelastic, while for a luxurious product it is
elastic.

❏ Availability of substitutes. If more close substitutes are available, then the demand is highly elastic. But if lesser or no
substitutes are available. Then it is inelastic.

❏ Income level. People with high income are less influenced by price changes, while lower income group are influenced
more.

❏ Postponement of consumption. Goods whose consumption can be postponed are highly elastic. While goods for which
the consumption cannot be postponed. E,.g medicines. Demand for such goods becomes inelastic.

❏ Number of uses. Commodity with several uses (eg Electricity) has elastic demand. When price of such commodity
increases, then it is generally put to only more urgent uses. As a result, its demand falls. Whereas commodity with single
use face inelastic demand.

❏ Share in total expenditure. If a high proportion of a consumer's income is spent on a single commodity (eg a car) It would
face elastic demand.

❏ Time. Demand is generally inelastic in the short run, while it is elastic in the long run, as there would be more substitutes
available.

32
❏ Habits. If the consumer has become habitual for a certain commodity. That commodity would face inelastic demand (eg
Tobacco)

Demand Forecasting

Demand Forecasting refers to the process of predicting the future demand for the firm's product. In other words, demand
forecasting is comprised of a series of steps that involves the anticipation of demand for a product in future under both
controllable and uncontrollable factors.

Objectives > Factors > Steps

Objectives of demand forecasting

Short term objectives

❏ Production policy

❏ Price policy

❏ Controlling sales

❏ Arranging finance

Long term objectives

❏ Determination of production capacity

❏ Planning long term activities

❏ Labour requirement

Factors affecting demand forecasting

❏ Price of Goods ❏ Type of Goods ❏ Competition ❏ Technology ❏ Economic Perspective

Steps in Demand forecasting

1. Setting the Objectives 2. Determining the Time Period 3. Selecting a Suitable Demand Forecasting Method 4.
Collecting the Data (primary or secondary) 5. Estimating the Results (predictions and estimation)

Steps in Demand forecasting

1. Setting the Objectives: The purpose for which the demand forecasting is being done must be clear. Whether it is for
short-term or long-term, the market share of the product, the market share of the organisation, competitors share, etc.

2. Determining the Time Period: The defined objectives are supported by the period for which the forecasting is being
done. The demand for a commodity varies over the period. There is a negligible change in price, income or other factors in
the short run. But there may be considerable difference in over a long-term, affecting the demand of a commodity.

3. Selecting a Suitable Demand Forecasting Method: Demand forecasting is based on specific evidence and is determined
using a particular technique or method. The method of prediction must be selected wisely. It is dependent on the
information available, the purpose of predicting and the period it is done for.

4. Collecting the Data: Forecasting is based on past experiences and data. This data or information can be primary or
secondary.

5. Estimating the Results: The data so collected is arranged in a systematic and meaningful manner. The past performance
of a product in the market is analysed on this basis. Accordingly, future sales prediction and demand estimation are done.

33
Methods of demand forecasting
Proper judgment along with the scientific formula is needed to correctly predict the future demand for a product
or service. Some methods of demand are:
1] Survey of Buyer’s Choice When the demand needs to be forecasted in the short run, say a year, then the most
feasible method is to ask the customers directly what they intend to buy in the forthcoming time period. Thus,
under this method, potential customers are directly interviewed. This survey can be done in any of the following
ways:
a. Complete Enumeration Method: Under this method, nearly all the potential buyers are asked about their
future purchase plans.
b. Sample Survey Method: Under this method, a sample of potential buyers are chosen scientifically and only
those chosen are interviewed.
c. End-use Method: It is especially used for forecasting the demand of the inputs. Under this method, the final
users i.e. the consuming industries and other sectors are identified.

2] Collective Opinion Method

Under this method, the salesperson of a firm predicts the estimated future sales in their region. The individual
estimates are aggregated to calculate the total estimated future sales. These estimates are reviewed in the light
of factors like future changes in the selling price, product designs, changes in competition, advertisement
campaigns, the purchasing power of the consumers, employment opportunities, population, etc.
This method assumes that as the salesmen are closest to the consumers they are more likely to understand the
changes in their needs and demands. They can also easily find out the reasons behind the change in their tastes.

3] Barometric Method
This method is based on the past demands of the product and tries to project the past into the future. The
economic indicators are used to predict the future trends of the business. Based on future trends, the demand for
the product is forecasted. An index of economic indicators is formed. There are three types of economic
indicators, viz. leading indicators, lagging indicators, and coincident indicators.
The leading indicators are those that move up or down ahead of some other series. The lagging indicators are
those that follow a change after some time lag. The coincident indicators are those that move up and down
simultaneously with the level of economic activities.

4] Market Experiment Method

Another one of the methods of demand forecasting is the market experiment method. Under this method, the
demand is forecasted by conducting market studies and experiments on consumer behavior under actual but
controlled, market conditions. Certain determinants of demand that can be varied are changed and the
experiments are done keeping other factors constant. However, this method is very expensive and time-
consuming.

5] Expert Opinion (Delphi) Method

Usually, market experts have explicit knowledge about the factors affecting demand. Their opinion can help in
demand forecasting. Under this method, experts are given a series of carefully designed questionnaires and are
asked to forecast the demand. They are also required to give the suitable reasons. The opinions are shared with
the experts to arrive at a conclusion. This is a fast and cheap technique.

34
6] Statistical Methods
The statistical method is one of the important methods of demand forecasting. Statistical methods are scientific,
reliable and free from biases. The major statistical methods used for demand forecasting are:
a. Trend Projection Method: This method is useful where the organization has a sufficient amount of accumulated
past data of the sales. This date is arranged chronologically to obtain a time series. Thus, the time series depicts
the past trend and on the basis of it, the future market trend can be predicted. It is assumed that the past trend
will continue in the future. Thus, on the basis of the predicted future trend, the demand for a product or service
is forecasted.
b. Regression Analysis: This method establishes a relationship between the dependent variable and the
independent variables. In our case, the quantity demanded is the dependent variable and income, the price of
goods, the price of related goods, the price of substitute goods, etc. are independent variables. The regression
equation is derived assuming the relationship to be linear. Regression Equation: Y = a + bX. Where Y is the
forecasted demand for a product or service.

Market Classification
What is a Market ? In general sense, the term “market” refers to a particular place where
goods are purchased and sold. But, in economics, market is used in a wide perspective. In
economics, the term “market” does not mean a particular place but the whole area where
the buyers and sellers of a product are spread. ● In ordinary language, a market refers to a
place where the buyers and sellers of a commodity gather and strike bargains. ● In
economics, however, the term “Market” refers to a market for a commodity. E.g. Cloth
market; furniture market; etc. ● According to Chapman, “the term market refers not
necessarily to a place and always to a commodity and buyers and sellers who are in direct
competition with one another”. ● According to the French economist Cournot, “Market is
not any particular place in which things are bought and sold, but the whole of any region in
which buyers and sellers are in such free intercourse with each other that the prices of the
same goods tend to equality easily and quickly”, A market has following features of a market:
(mandate features) 1. A region. A market does not refer to a fixed place. It covers a region,
which may be a town, state, country or even world. 2. Existence of buyers and sellers.
Market refers to the network of potential buyers and sellers who may be at different places.
3. Existence of commodity or service. The exchange transactions between the buyers and
sellers can take place only when there is a commodity or service to buy and sell. 4.
Bargaining for a price between potential buyers and sellers. 5. Knowledge about market
conditions. Buyers and sellers are aware of the prices offered or accepted by other buyers
and sellers through any means of communication. 6. One price for a commodity or service at
a given time

35
1. Perfect Competition Market: A perfectly competitive market is one in which ● the
number of buyers and sellers is very large, ● all engaged in buying and selling a
homogeneous product without any artificial restrictions and ● possessing perfect
knowledge of market at a time According to R.G. Lipsey, “Perfect competition is a market
structure in which all firms in an industry are price- takers and in which there is freedom
of entry into, and exit from, industry.”

36
37
Characteristics of Perfect Competition: The following are the conditions for the existence of
perfect competition: (a) Large Number of Buyers and Sellers: The first condition is that the
number of buyers and sellers must be so large that none of them individually is in a position
to influence the price and output of the industry as a whole. The demand of individual buyer
relative to the total demand is so small that he cannot influence the price of the product by
his individual action. Similarly, the supply of an individual seller is so small a fraction of the
total output that he cannot influence the price of the product by his action alone (b)
Freedom of Entry or Exit of Firms: The next condition is that the firms should be free to enter
or leave the industry. (c) Homogeneous Product: Each firm produces and sells a
homogeneous product so that no buyer has any preference for the product of any individual
seller over others. This is only possible if units of the same product produced by different
sellers are perfect substitutes. In other words, the cross elasticity of the products of sellers is
infinite. No seller has an independent price policy. Commodities like salt, wheat, cotton and
coal are homogeneous in nature. (d) Absence of Artificial Restrictions: The next condition is
that there is complete openness in buying and selling of goods. Sellers are free to sell their
goods to any buyers and the buyers are free to buy from any sellers. In other words, there is
no discrimination on the part of buyers or sellers. (e) Profit Maximisation Goal: Every firm
has only one goal of maximising its profits. (f) Perfect Mobility of Goods and Factors: Another
requirement of perfect competition is the perfect mobility of goods and factors between
industries. Goods are free to move to those places where they can fetch the highest price.
Factors can also move from a low-paid to a high-paid industry. (g) Perfect Knowledge of
Market Conditions: This condition implies a close contact between buyers and sellers. Buyers

38
and sellers possess complete knowledge about the prices at which goods are being bought
and sold, and of the prices at which others are prepared to buy and sell. They also have
perfect knowledge of the place where the transactions are being carried on. (h) Absence of
Transport Costs: Another condition is that there are no transport costs in carrying of product
from one place to another. This condition is essential for the existence of perfect competition
which requires that a commodity must have the same price everywhere at any time. If
transport costs are added to the price of the product, even a homogeneous commodity will
have different prices depending upon transport costs from the place of supply. (i) Absence of
Selling Costs: Under perfect competition, the costs of advertising, sales-promotion, etc. do
not arise because all firms produce a homogeneous product. Perfect Competition vs Pure
Competition: ● Perfect competition is often distinguished from pure competition, but they
differ only in degree. The first five conditions relate to pure competition while the remaining
four conditions are also required for the existence of perfect competition. ● The practical
importance of perfect competition is not much in the present times for few markets are
perfectly competitive except those for staple food products and raw materials. ● Though the
real world does not fulfil the conditions of perfect competition, yet perfect competition is
studied for the simple reason that it helps us in understanding the working of an economy,
where competitive behaviour leads to the best allocation of resources and the most efficient
organisation of production. 2. Monopoly Market: Monopoly is a market situation in which
there is ● only one seller of a product with barriers to entry of others ● The product has no
close substitutes - The cross elasticity of demand with every other product is very low. This
means that no other firms produce a similar product. According to D. Salvatore, “Monopoly
is the form of market organisation in which there is a single firm selling a commodity for
which there are no close substitutes.” Thus the monopoly firm is itself an industry and the
monopolist faces the industry demand curve. Characteristics of Monopoly: The main
features of monopoly are as follows: a. Under monopoly, there is one producer or seller of a
particular product and there is no difference between a firm and an industry. Under
monopoly a firm itself is an industry. b. A monopoly may be individual proprietorship or
partnership or joint stock company or a cooperative society or a government company. c. A
monopolist has full control on the supply of a product. Hence, the elasticity of demand for a
monopolist’s product is zero. d. There is no close substitute of a monopolist’s product in the
market. Hence, under monopoly, the cross elasticity of demand for a monopoly product with
some other good is very low. e. There are restrictions on the entry of other firms in the area
of monopoly product. f. A monopolist can influence the price of a product. He is a price-
maker, not a price-taker. g. Pure monopoly is not found in the real world. h. Monopolist
cannot determine both the price and quantity of a product simultaneously. i. Monopolist’s
demand curve slopes downwards to the right. That is why, a monopolist can increase his
sales only by decreasing the price of his product and thereby maximise his profit. 3. Duopoly:
● Duopoly is a special case of the theory of oligopoly in which there are only two sellers. ● A
duopoly is a form of oligopoly, where only two companies dominate the market. ● The
companies in a duopoly tend to compete against one another, reducing the chance of
monopolistic market power. ● Visa and Mastercard are examples of a duopoly that
dominates the payments industry in Europe and the United States. ● One disadvantage of
duopolies is that consumers have little choice in products. ● Another disadvantage of
duopolies is that the two players may collude and increase prices for the consumer. 4.
Oligopoly: Oligopoly is a market situation in which there are a few firms selling homogeneous
or differentiated products. It is difficult to pinpoint the number of firms in ‘competition
among the few.’ With only a few firms in the market, the action of one firm is likely to affect

39
the others. An oligopoly industry produces either a homogeneous product or heterogeneous
products. The former is called pure or perfect oligopoly and the latter is called imperfect or
differentiated oligopoly. Pure oligopoly is found primarily among producers of such industrial
products as aluminium, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among
producers of such consumer goods as automobiles, cigarettes, soaps and detergents, TVs,
rubber tyres, refrigerators, etc. Characteristics of Oligopoly: In addition to fewness of sellers,
most oligopolistic industries have several common characteristics which are explained below:
(a) Interdependence: There is recognised interdependence among the sellers in the
oligopolistic market. Each oligopolist firm knows that changes in its price, advertising,
product characteristics, etc. may lead to counter-moves by rivals. When the sellers are a few,
each produces a considerable fraction of the total output of the industry and can have a
noticeable effect on market conditions. (b) Advertisement: The main reason for this mutual
interdependence in decision making is that one producer’s fortunes are dependent on the
policies and fortunes of the other producers in the industry. It is for this reason that
oligopolist firms spend much on advertisement and customer services. If, one oligopolist
advertises his product, others have to follow him to keep up their sales. (c) Competition: This
leads to another feature of the oligopolistic market, the presence of competition. Since
under oligopoly, there are a few sellers, a move by one seller immediately affects the rivals.
So each seller is always on the alert and keeps a close watch over the moves of its rivals in
order to have a counter-move. This is true competition. (d) Barriers to Entry of Firms: As
there is keen competition in an oligopolistic industry, there are no barriers to entry into or
exit from it. However, in the long run, there are some types of barriers to entry which tend to
restraint new firms from entering the industry. They may be: (i) Economies of scale enjoyed
by a few large firms; (ii) control over essential and specialised inputs; (iii) high capital
requirements due to plant costs, advertising costs, etc. (iv) exclusive patents and licenses;
and (v) the existence of unused capacity which makes the industry unattractive. When entry
is restricted or blocked by such natural and artificial barriers, the oligopolistic industry can
earn long-run super normal profits. 5. Monopolistic Competition: Monopolistic competition
refers to a market situation where there are many firms selling a differentiated product.
“There is competition which is keen, though not perfect, among many firms making very
similar products.” No firm can have any perceptible influence on the price-output policies of
the other sellers nor can it be influenced much by their actions. Thus monopolistic
competition refers to competition among a large number of sellers producing close but not
perfect substitutes for each other. It’s Features: The following are the main features of
monopolistic competition: (a) Large Number of Sellers: In monopolistic competition the
number of sellers is large. They are “many and small enough” but none controls a major
portion of the total output. (b) Non-price Competition: Under monopolistic competition, a
firm increases sales and profits of his product without a cut in the price. The monopolistic
competitor can change his product either by varying its quality, packing, etc. or by changing
promotional programmes. (c) Product Differentiation: One of the most important features of
the monopolistic competition is differentiation. Product differentiation implies that products
are different in some ways from each other. They are heterogeneous rather than
homogeneous so that each firm has an absolute monopoly in the production and sale of a
differentiated product. There is, however, slight difference between one product and other in
the same category. Products are close substitutes with a high cross-elasticity and not perfect
substitutes. Product “differentiation may be based upon certain characteristics of the
products itself, such as exclusive patented features; trade-marks; trade names; peculiarities
of package or container, if any; or singularity in quality, design, colour, or style. It may also

40
exist with respect to the conditions surrounding its sales.” (c) Freedom of Entry and Exit of
Firms: Another feature of monopolistic competition is the freedom of entry and exit of firms.
As firms are of small size and are capable of producing close substitutes, they can leave or
enter the industry or group in the long run. (d) Nature of Demand Curve: Under monopolistic
competition no single firm controls more than a small portion of the total output of a
product. No doubt there is an element of differentiation nevertheless the products are close
substitutes. As a result, a reduction in its price will increase the sales of the firm but it will
have little effect on the price-output conditions of other firms, each will lose only a few of its
customers. (e) Independent Behaviour: In monopolistic competition, every firm has
independent policy. Since the number of sellers is large, none controls a major portion of the
total output. No seller by changing its price-output policy can have any perceptible effect on
the sales of others and in turn be influenced by them. Kinked Demand Curve ● In an
oligopolistic market, the kinked demand curve hypothesis states that the firm faces a
demand curve with a kink at the prevailing price level. ● The curve is more elastic above the
kink and less elastic below it. ● This means that the response to a price increase is less than
the response to a price decrease. ● oligopolist lowers the price > competitors follow the
price cut > Hence, the lower portion of the curve is inelastic. It implies that if an oligopolist
lowers the price, he can obtain very little sales. ● oligopolist increases the price > increases
the competitors’ sales > no motivation to match the price rise > reduction in sales to
oligopolist. Hence, the upper portion of the curve is elastic. If a firm raises the price of a
product, then it experiences a large fall in sales.

41
42