ME SESSION 1.ppt

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PAN African eNetwork Project

Masters of Business Administration

Managerial Economics

Semester - I

Ms. Geeta Jaglan

MANAGERIAL ECONOMICS

The application of economics’ theories and principles in managerial problems with the purpose of optimization of decision making.

Decision making involves the activities regarding production, distribution and consumption.

The use of Economic Analysis in management is to make business decisions involving the best use (allocation) of scarce resources.

Economic Theory helps managers to collect the relevant information and process it in order to arrive at the optimal decision.Given the goals of a firm, a decision is OPTIMAL if it brings the firm closest to its goals

Management Decision Problems

•Product Price and Output•Production Technique•Stock Levels•Advertising Media and intensity•Labor hiring and firing•Investment and Financing

Decision Making Process

•Identifying the problem •Generating the alternative course of action •Evaluating the alternative •Selecting the best alternative •Implementing the decision; and •Evaluating the decision

Nature of Decision

•What goods shall firm produce? •How should firm raise the necessary capital and what shall be its legal form. •What technique shall be adopted, and what shall be the scale of operations? •Where production is located? •How shall its product be distributed? •How shall resources be combined? •What shall be the size of output? •How shall it deal with its employees?

Types of Decision

•Organizational and personal decisions •Basic and routine decisions

•Programmed and non-programmed decisions.

Conditions Affecting Decision Making

•Certainty

•Risk

•Uncertainty

Economic Conditions

•Market Structure•Supply and Demand conditions•State of Technology•Govt. Regulations•International Dimensions•Future Macroeconomic factors

Decision Making Model

•The Classical Model•The Administrative Model

The Classical Model

•The manager has completed information about the decision situation and operations under a condition of certainty. •The problem is clearly defined, and the decision-maker has knowledge of all possible alternatives and their outcomes.

•Through the use of quantitative techniques, rationality, and logic, the decision-maker evaluates the alternatives and selects the optimum alternative -the one that will maximize the decision situation by offering the best solution to the problem.

The Administrative Model•The manager has incomplete information about the decision situation and operates under a condition of risk or uncertainty. •The problem is not clearly defined, and the decision-maker has limited knowledge of possible alternatives and their outcomes. •The decision-maker satisfies by choosing the first satisfactory alternative- one that will resolve the problem situation by offering a good solution to the problem.

Tools of Decision Making

•Marginal Analysis•Linear Programming•Game Theory•Optimization•Forecasting

Demand Forecasting

Estimation of demand for a product in a forecast year/ period is termed as Demand forecast. Demand forecast is a must for a firm operating its business as today's market is competitive, dynamic and volatile.

Purpose of Demand Forecasting

•Better planning and allocation of resources •Appropriate production scheduling •Inventory control •Determining appropriate pricing policies •Setting s les targets and establishing controls and incentives. •Planning a new unit or expanding existing one •Planning long term financial requirements

•Planning Human Resource Development strategies.

Steps Involved in Forecasting

•Identification of objective •Determining the nature of goods under consideration. •Selecting a proper method of forecasting. •Interpretation of results.

Period of forecasting •Short run forecasting: In short run forecasting, we look for factors which bring fluctuation in demand pattern in the market for example weather conditions like monsoon affecting the demand. •Medium run forecasting: In medium run forecasting is done basically for timing of an activity like advertising expenditure.

•Long run forecasting: It is done to ascertain the validity of trend. It is done for decision like diversification.

Levels of Forecasting

Macroeconomic forecasting is concerned with business conditions of the whole

economy. It is measured with the help of indices like wholesale price index, consumer

price index.

•Industry demand forecasting gives indication to firm regarding direction in which the whole industry will be moving. It is used to decide the way the firm should plan for future in relation to the industry.

•Firm demand forecasting is done for planning companies overall operations like sales forecasting etc.

•Product line forecasting helps the firm to decide which of the product or products should have priority in the allocation of firm's limited resources. •General purpose or specific purpose forecast helps the firm in taking general factors into consideration while forecasting for demand. contd

•Forecast of established product or a new product

•Types of commodity for which forecast is to be done. Goods can be broadly classified into capital goods, consumer durable and Non-durable consumer goods. For each of these categories of goods there is a distinctive pattern of demand.

Methods of Forecasting

Qualitative Methods

Surveys Technique•Survey of business executives, plant and equipment, expenditure plans. Basically compilation of expenditure plans of related industries. •Survey of plans for inventory changes and sales expectations. •Survey of consumer expenditure plans.

Opinion Polls

•Consumer survey: In this method the consumers are contacted personally to disclose their future purchase plans. This could be of two types-Complete enumeration and sample survey.

•Sales force opinion method: In this method people who are closest to the market( sales peoples) are asked for their opinion on future demand. Then opinion of different people is compiled to get overall demand forecast.

•Expert Opinion (Delphi Technique): Opinions of different experts are taken and compiled. If there are discrepancies between the different viewpoints, successive rounds of iterations are undertaken taking into account the opinions of other experts, until near consensus emerges

Statistical Methods

Time Series Analysis Forecasts on the basis of an analysis of historical time series data Trend Projection Method

Based on the assumption that there is an identifiable trend in the variable to be forecast which will continue in the future

Time Series data is used to fit a trend line on the variable under forecast either graphically or by statistical techniques

Y = a + bt; t → timeForecasting is done by extrapolating the

trend line into the future.

Barometric Methods

Leading Indicator Method : correlated with the variable to be forecast. These indicators tend normally to anticipate turning points in a business cycle.• Coincident indicators: These are indicators which move in step or coincide with movements in general economic activity or business cycle. •Lagging indicator: These are indicators which lag the movements in economic activity or business cycle.

Regression Method•Identification of variables which influence the demand for the good whose function is under estimation. •Collection of historical data on all relevant variables.

•Choosing an appropriate form of the function. •Estimation of the function

Simultaneous Equation Method(Econometric Models)

Econometric forecasting models range from single equation models of the demand that the firm faces for its product to large multiple equation models describing hundreds of sectors and industries of the economy. Use estimating equations based on Economic Theory

Input – Output Forecasting

Input output analysis was introduced by Prof. Leontief. With this technique the firm can also forecast using Input output tables. It shows the use of the output of each industry as input by other industries and for final consumption. Input and output analysis allow us to trace through all these inter industry input and outputs flow though out the economy and to determine the total increase of all the inputs required to meet the increased demand.

Risks in Demand Forecasting

•Overestimation of demand

•Underestimation of demand

First risk arises from entirely unforeseen events such as war, political upheavals and natural disasters. The second risk arises from inadequate analysis of the market.

Prevention Measures

•Carefully defining the market for the product to include all potential users of the market and considering the possibility of product substitution.

•Dividing total industry demand into its components and analyzing each component separately.

Meaning of Demand

Conceptually, demand can be defined as the desire for a good backed by the ability and willingness to pay for it. The desire without adequate purchasing power and willingness to pay do not become effective demand and only an effective demand matters in economic analysis and business decisions.

Types of Demand

The demand for various commodities is generally classified on the basis of the consumers of the product, suppliers of the product, nature of goods, duration of the consumption of the commodity, interdependence of demand, period of demand and nature of use of the commodity(intermediate or final).

•Individual and Market Demand •Autonomous and derived demand

•Demand for durable and nondurable goods

•Demand for firm’s product and industry product

•Demand for consumers and producers goods

Individual and Market Demand

The quantity of a commodity which an individual is willing to buy at a particular price during a specific time period given his money income, his taste and prices of other commodities is called individual’s demand for a commodity. On the other hand market demand of a commodity is the summation of individual demand by all the consumers. Market demand is a multivariate relationship and determined by many factors simultaneously.

Demand for durable and nondurable goods

Durable goods are those whose total utility is not exhausted in a single or short run use. Such goods can be used repeatedly over a period of time. Durable goods may be consumer goods as well as producer goods.

The demand for nondurable goods depends largely on their prices, consumer income and is subject to frequent change.

Autonomous and derived demand

The demand for a commodity that arises on its own out of a natural desire to consume or possesses a commodity independent of the demand of other commodities, the demand for the product is termed as independent.

Commodities like tea and vegetables do come on absolute terms. On the other hand if the demand for a product is tied to the demand for some parent product, the demand is termed as derived demand.

Demand for firm’s product and industry product

Firm’s demand denotes the demand for the products by a particular company or firm whereas industry demand is the aggregation of demand for the product of all the firms of an industry as a whole.

Demand for consumers and producers goods

Consumer goods are those, which are, meant for the final consumption by the consumers or the end users. Producer's goods on the other hand are used for the production of consumer goods or they are intermediate goods, which are further processed upon to convert them into a form to be used by the end user. Another distinction is that the demand for producer’s goods is derived demand and it indirectly depends on the demand for the consumer goods which the producer goods is used to produce.

Determinants of Demand

•Own Price•Prices of related goods → Substitutes and Complements•Income•Tastes & Preferences•Expectations•Population•Other exogenous factors

Demand Analysis

Law of Demand – There is Inverse relationship between price and quantity demanded ceteris paribus i.e.,other factors remaining constant.

Demand Schedule – A list / table showing quantity demanded of a good at different prices, all other things being held constant

Demand Function – The determinants of quantity demanded when summarized in the form of functional notations are called a demand function. A typical demand function can be specified as follows:

QXD = f ( px, p1,…..pn, Y, T, Ey, Ep, u)

Demand Curve – Represents the relation between price and quantity demanded of a good, all other things being held constant.

Linear Demand CurveQ

Non – Linear Demand Curve

Demand Curve

Perfectly Inelastic Demand eD

Perfectly Elastic Demand eD

P = ∞

Less than Perfectly inelastic demand 0 < eD

p < 1Less than perfectly elastic demand 1 < eD

p < ∞

Unitary Elastic Demand Curve eD

Change in Quantity Demanded → A movement along the demand curve in response to a change in price – Expansion / Contraction of Demand

Change in Demand → A movement of the entire demand curve in response to a change in one of the other determinants of demand – Shift in Demand

Effect of a Price Change

Income Effect – A price change causes Real Income to change and therefore consumption of both goods changes

Substitution Effect – Price change of one good causes the relative price of the two goods to change and consumers substitute the relatively cheaper good for the more expensive one

Elasticity of Demand

Responsiveness of quantity demanded towards a change in the concerned variable or factor.

Price Elasticity of Demand - refers to the responsiveness of quantity demanded to price changes. Ed = dQ/Q ∕ dP/PDefined as the percentage change in quantity demanded divided by the percentage change in priceEPd is negative due to the inverse relationship between quantity and price, but we consider the absolute value for interpretation

Determinants of Price Elasticity of Demand

•Number and availability of Substitutes•Expenditure on the commodity in relation to the consumer’s budget•Nature of the product and extent of its use•Length of time period under consideration•Consumers’ Preferences

Price elasticity and Decision Making

Information about price elasticities can be extremely useful to managers as they contemplate pricing decisions.

If demand is inelastic at the current price, a price decrease will result in a decrease in total revenue.Alternatively, reducing the price of a product with elastic demand would cause revenue to increase.* Remember TR = P*Q

We may summarize this relationship as follows:

•If the demand is inelastic (e < 1) an increase in price leads to an increase in total revenue and vice versa.•If the demand is elastic (e>1) an increase in price will lead to a decrease in total revenue and vice versa.•If the demand has unitary elasticity (e =1), total revenue is not affected by changes in price.

Income Elasticity of Demand

Measures the responsiveness of quantity demanded of a good to changes in Income. Ey = dQ/y ∕ dy/Q

Classification of Goods:Normal Goods – Demand Increases as Income increases (eY >0)Inferior Goods – Demand decreases as consumer Income increases (eY < 0)Basic Necessities – Commodities like salt, food grains etc for which demand is relatively inelastic and does not vary with income after a point

Cross Elasticity of Demand

•The proportionate change in the quantity demanded of x commodity resulting from a proportionate change in the price of y commodity. Exy = dQx/Qx ∕ dPy/Py•The sign of cross elasticity is negative if x and y are complementary goods and positive if x and y are substitutes. •The higher the value of the cross elasticity the stronger will be the degree of substitutability or complementarity of x and y.

Exceptions to the Law of Demand Upward Sloping Demand Curve

•Giffen Goods – a subclass of Inferior goods for which the income effect outweighs the substitution effect•Veblen Products / Snob effect – Goods that have a snob value attached to them for which demand actually increases as price goes up•Speculative Effect – In periods of rising prices, anticipation of future increases may cause consumers to demand more

•Bandwagon Effect – Occurs when people demand a commodity only because others are demanding it and in order to be fashionable

•Emergencies like war, famine etc.

Theory of Consumer Behaviour

The consumer is assumed to be rational. Given his income and the market prices of the various commodities, he plans the spending of his income so as to attain the highest possible satisfaction or utility. This is the axiom of utility maximization. There are two basic approaches to compare the utilities, the cardinalist approach and the ordinalist approach.

The Cardinal Utility TheoryThe cardinal school stated that utility can be measured. Under certainty i.e., complete knowledge of market conditions and income levels over the planning period utility can be measured in monetary units, called utils. There are certain assumptions of cardinal utility theory.

•Rationality of consumer•Constant marginal utility of money•Diminishing marginal utility•Total utility is additive

Equilibrium of Consumer

Assuming the simple model of a single commodity x, the consumer can either buy x or retain his money income y. Under these conditions the consumer is in equilibrium when the marginal utility of x is equated to its market price.

MUx = Px

The Ordinal Utility TheoryThe ordinalist school postulated the utility is not measurable, but is an ordinal magnitude. It suffices for the consumer to be able to rank the various baskets of goods according to the satisfaction derived. The main ordinal theory is known as the indifference-curve theory is based on certain assumptions.

Assumptions of ordinal approach

•Rationality of consumer•Utility is ordinal•Diminishing Marginal rate of substitution•Consistency and transitivity of choice•Total utility depends on the quantities of the commodities consumed

Indifference Curve

Indifference curve is the locus of various combinations Of two commodities, on both the axis, giving same level of satisfaction.

Properties of Indifference Curve

•An indifference curve has a negative slope•The further away from the origin an indifference curve lies, the higher the utility it denotes•Indifference curve do not intersect•The indifference curves are convex to the origin

Equilibrium of Consumer

The consumer is in equilibrium when he maximizes his utility, given his income and the market prices. Two conditions must be fulfilled for consumer,s equilibrium.

•The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices. This is necessary but not sufficient condition.

•The second condition is that the indifference curve be convex to the origin. This condition is fulfilled by the axiom of diminishing marginal rate of substitution of x for y and vice versa.

MRSxy = MUx/MUy = Px/Py

Thank You

Please forward your query To: gdeshwal@amity.eduCC: manoj.amity@panafnet.com

ME SESSION 1.ppt

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