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LESSON1
NATURE & SCOPE OF MANAGERIAL ECONOMICS
The terms Managerial Economics and Business Economics are often
used interchangeably. However, the terms Managerial Economics has
become more popular and seems to displace Business Economics.
DECISION-MAKING AND FORWARD PLANNING
The chief function of a management executive in a business firm is
decision-making and forward planning. Decision-making refers to theprocess of selecting one action from two or more alternative courses of
action. Forward planning on the other hand is arranging plans for the
future. In the functioning of a firm the question of choice arises
because the available resources such as capital, land, labour and
management, are limited and can be employed in alternative uses. The
decision-making function thus involves making choices or decisions
that will provide the most efficient means of attaining an
organisational objectives, for example profit maximization. Once a
decision is made about the particular goal to be achieved, plans for
the future regarding production, pricing, capital, raw materials and
labour are prepared. Forward planning thus goes hand in hand with
decision-making. The conditions in which firms work and take
decisions, is characterised with uncertainty. And this uncertainty not
only makes the function of decision-making and forward planning
complicated but also adds a different dimension to it. If the knowledge
of the future were perfect, plans could be formulated without error
and hence without any need for subsequent revision. In the real
world, however, the business manager rarely has complete
information about the future sales, costs, profits, capital conditions.
etc. Hence, decisions are made and plans are formulated on the basis
of past data, current information and the estimates about future that
are predicted as accurately as possible. While the plans are
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implemented over time, more facts come into the knowledge of the
businessman. In accordance with these facts the plans may have to be
revised, and a different course of action needs to be adopted.
Managers are thus engaged n a continuous process of decision-making through an uncertain future and the overall problem that they
deal with is adjusting to uncertainty.
To execute the function of decision-making in an uncertain
frame-work, economic theory can be applied with considerable
advantage. Economic theory deals with a number of concepts and
principles relating to profit, demand, cost, pricing, production,
competition, business cycles and national income, which are aided byallied disciplines like accounting. Statistics and Mathematics also can
be used to solve or at least throw some light upon the problems of
business management. The way economic analysis can be used
towards solving business problems constitutes the subject matter of
Managerial Economics.
DEFINITION
According to McNair the Merriam, Managerial Economics consists of
the use of economic modes of thought to analyse business situations.
Spencer and Siegelman have defined Managerial Economics as
the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by
management.
The above definitions suggest that Managerial economics is the
discipline, which deals with the application of economic theory to
business management. Managerial Economics thus lies on the margin
between economics and business management and serves as the
bridge between the two disciplines. The following Figure 1.1 shows the
relationship between economics, business management and
managerial economics.
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APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT
The application of economics to business management or the
integration of economic theory with business practice, as Spencer and
Siegelman have put it, has the following aspects :
Reconciling traditional theoretical concepts of economicsin relation to the actual business behavior and conditions:
In economic theory, the technique of analysis is that of model
building. This involves making some assumptions and, drawing
conclusions on the basis of the assumptions about the behavior
of the firms. The assumptions, however, make the theory of the
firm unrealistic since it fails to provide a satisfactory
explanation of what the firms actually do. Hence, there is need
to reconcile the theoretical principles based on simplified
assumptions with actual business practice and developappropriate extensions and reformulation of economic theory.
For example, it is usually assumed that firms aim at maximising
profits. Based on this, the theory of the firm suggests how much
the firm will produce and at what price it would sell. In practice,
however, firms do not always aim at maximum profits (as they
may think of diversifying or introducing new product etc.) To
that extent, the theory of the firm fails to provide a satisfactoryexplanation of the firms actual behavior. Moreover, in actual
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business language, certain terms like profits and costs have
accounting concepts as distinguished from economic concepts.
In managerial economics, an attempt is made to merge the
accounting concepts with the economics, an attempt is made tomerge the accounting concepts with the economic concepts.
This helps in a more effective use of financial data related to
profits and costs to suit the needs of decision-making and
forward planning.
Estimating economic relationships: This involves themeasurement of various types of elasticities of demand such as
price elasticity, income elasticity, cross-elasticity, promotionalelasticity and cost-output relationships. The estimates of these
economic relationships are to be used for the purpose of
forecasting.
Predicting relevant economic quantities: Economic quantitiessuch as profit, demand, production, costs, pricing and capital
are predicated in numerical terms together with their
probabilities. As the business manager has to work in anenvironment of uncertainty, the future needs to be foreseen so
that in the light of the predicted estimates, decision-making and
forward planning may be possible.
Using economic quantities in decision-making and forwardplanning: This involves formulating business policies for
establishing future business plans. This nature of economic
forecasting indicates the degree of probability of various possibleoutcomes, i.e., losses or gains that will occur as a result of
following each one of the available strategies. Thus, a quantified
picture gets set up, that indicates the number of courses open,
their possible outcomes and the quantified probability of each
outcome. Keeping this picture in view, the business manager is
able to decide about which strategy should be chosen.
Understanding significant external forces: Applying economictheory to business management also involves understanding the
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important external forces that constitute the business environment
and with which a business must adjust. Business cycles,
fluctuations in national income and government policies pertaining
to taxation, foreign trade, labour relations, antimonopolymeasures, industrial licensing and price controls are typical
examples. The business manager has to appraise the relevance and
impact of these external forces in relation to the particular
business unit and its business policies.
CHARACTERISTICS OF MANAGERIAL ECONOMICS
There are certain chief characteristics of managerial economics, which
can help to understand the nature of the subject matter and help in aclear understanding of the following terms:
Managerial economics is micro-economic in character. This isbecause the unit of study is a firm and its problems. Managerial
economics does not deal with the entire economy as a unit of
study.
Managerial economics largely uses that body of economicconcepts and principles, which is known as Theory of the Firmor Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in
economics.
Managerial economics is concrete and realistic. I avoids difficultabstract issues of economic theory. But it also involves
complications ignored in economic theory in order to face the
overall situation in which decisions are made. Economic theoryignores the variety of backgrounds and training found in
individual firms. Conversely, managerial economics is
concerned more with the particular environment that influences
decision-making.
Managerial economics belongs to normative economics ratherthan positive economics. Normative economy is the branch of
economics in which judgments about the desirability of variouspolicies are made. Positive economics describes how the
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economy behaves and predicts how it might change. In other
words, managerial economics is prescriptive rather than
descriptive. It remains confined to descriptive hypothesis.
Managerial economics also simplifies the relations amongdifferent variables without judging what is desirable or
undesirable. For instance, the law of demand states that as
price increases, demand goes down or vice-versa but this
statement does not imply if the result is desirable or not.
Managerial economics, however, is concerned with what
decisions ought to be made and hence involves value
judgments. This further has two aspects: first, it tells what aimsand objectives a firm should pursue; and secondly, how best to
achieve these aims in particular situations. Managerial
economics, therefore, has been described as normative
microeconomics of the firm.
Macroeconomics is also useful to managerial economics since itprovides an intelligent understanding of the business
environment. This understanding enables a business executiveto adjust with the external forces that are beyond the
managements control but which play a crucial role in the well
being of the firm. The important forces are: business cycles,
national income accounting, and economic policies of the
government like those relating to taxation foreign trade, anti-
monopoly measures and labour relations.
DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS ANDECONOMICS
The difference between managerial economics and economics can be
understood with the help of the following points:
Managerial economics involves application of economicprinciples to the problems of a business firm whereas;
economics deals with the study of these principles only.
Economics ignores the application of economic principles to theproblems of a business firm.
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Managerial economics is micro-economic in character, however,Economics is both macro-economic and micro-economic.
Managerial economics, though micro in character, deals onlywith a firm and has nothing to do with an individuals economicproblems. But microeconomics as a branch of economics deals
with both economics of the individual as well as economics of a
firm.
Under microeconomics, the distribution theories, viz., wages,interest and profit, are also dealt with. Managerial economics on
the contrary is mainly concerned with profit theory and does not
consider other distribution theories. Thus, the scope ofeconomics is wider than that of managerial economics.
Economic theory assumes economic relationships and buildseconomic models. Managerial economics adopts, modifies and
reformulates the economic models to suit the specific conditions
and serves the specific problem solving process. Thus,
economics gives the simplified model, whereas managerial
economics modifies and enlarges it. Economics involves the study of certain assumptions like in the
law of proportion where it is assumed that The variable input
as applied, unit by unit is homogeneous or identical in amount
and quality. Managerial economics on the other hand,
introduces certain feedbacks. These feedbacks are in the form of
objectives of the firm, multi-product nature of manufacture,
behavioral constraints, environmental aspects, legal constraints,constraints on resource availability, etc. Thus managerial
economics, attempts to solve the complexities in real life, which
are assumed in economics. this is done with the help of
mathematics, statistics, econometrics, accounting, operations
research, etc.
OTHER TERMS FOR MANAGERIAL ECONOMICS
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Certain other expressions like economic analysis for business
decisions and economics of business management have also been
used instead of managerial economics but they are not so popular.
Sometimes expressions like Economics of the Enterprise, Theory ofthe Firm or Economics of the Firm have also been used for
managerial economics. It is, however, not appropriate t use theses
terms because managerial economics, though primarily related to the
economics of the firm, differs from it in the following respects:
First, Economics of the Firm deals with the theory of the firm,which is a body of economic principles relating to the firm alone.
Managerial economics on the other hand deals with the,application of the same principles to business.
Secondly, the term Economics of the firm is too simple in itsassumptions whereas managerial economics has to reckon with
actual business behaviour, which is much more complex.
SCOPE OF MANAGERIAL ECONOMICS
As regards the scope of managerial economics, there is no generaluniform pattern. However, the following aspects may be said to be
inclusive under managerial economics:
Demand analysis and forecasting. Cost and production analysis. Pricing decisions, policies and practices. Profit management. Capital management.
These aspects may also be defined as the Subject-Matter of
Managerial Economics. In recent years, there is a trend towards
integrations of managerial economics and operations research. Hence,
techniques such as linear programming, inventory models and theory
of games have also been regarded as a part of managerial economics.
Demand Analysis and Forecasting
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A business firm is an economic Organisation, which transforms
productive resources into goods that are to be sold in a market. A
major part of managerial decision-making depends on accurate
estimates of demand. This is because before production schedules canbe prepared and resources are employed, a forecast of future sales is
essential. This forecast can also guide the management in maintaining
or strengthening the market position and enlarging profits. The
demand analysis helps to identify the various factors influencing
demand for a firms product and thus provides guidelines to
manipulate demand. Demand analysis and forecasting, thus, is
essential for business planning and occupies a strategic place inmanagerial economics. It comprises of discovering the forces
determining sales and their measurement. The chief topics covered in
this are:
Demand determinants Demand distinctions Demand forecasting.
Cost and Production Analysis
A study of economic costs, combined with the data drawn from the
firms accounting records, can yield significant cost estimates. These
estimates are useful for management decisions. The factors causing
variations in costs must be recognised and thereby should be used for
taking management decisions. This facilitates the management toarrive at cost estimates, which are significant for planning purposes.
An element of cost uncertainty exists in this because all the factors
determining costs are not always known or controllable. Therefore, it
is essential to discover economic costs and measure them for effective
profit planning, cost control and sound pricing practices. Production
analysis is narrower in scope than cost analysis. The chief topics
covered under cost and production analysis are: Cost concepts and classifications
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Cost-output relationships Economics of scale Production functions Cost control.
Pricing Decisions, Policies and Practices
Pricing is a very important area of managerial economics. In fact price
is the origin of the revenue of a firm. As such the success of a usiness
firm largely depends on the accuracy of price decisions of that firm.
The important aspects dealt under area, are as follows:
Price determination in various market forms Pricing methods Differential pricing product-line pricing and price forecasting.
Profit Management
Business firms are generally organised with the purpose of making
profits. In the long run, profits provide the chief measure of success.
In this connection, an important point worth considering is the
element of uncertainty existing about profits. This uncertainty occurs
because of variations in costs and revenues. These are caused byfactors such as internal and external. If knowledge about the future
were perfect, profit analysis would have been a very easy task.
However, in a world of uncertainty, expectations are not always
realised. Thus profit planning and measurement make up the difficult
area of managerial economics. The important aspects covered under
this area are:
Nature and measurement of profit. Profit policies and techniques of profit planning.
Capital Management
Among the various types and classes of business problems, the most
complex and troublesome for the business manager are those relating
to the firms capital investments. Capital management implies
planning and control and capital expenditure. In this procedure,
relatively large sums are involved and the problems are so complex
that their disposal not only requires considerable time and labour but
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also top-level decisions. The main elements dealt with cost
management are:
Cost of capital
Rate of return and selection of projects.The various aspects outlined above represent the major uncertainties,
which a business firm has to consider viz., demand uncertainty, cost
uncertainty, price uncertainty, profit uncertainty and capital
uncertainty. We can, therefore, conclude that managerial economics is
mainly concerned with applying economic principles and concepts to
adjust with the various uncertainties faced by a business firm.
USES OF MANAGERIAL ECONOMICSManagerial economics achieves several objectives. The principal
objectives are as follows:
It presents those aspects of traditional economics, which arerelevant for business decision-making in real life. For this
purpose, it picks from economic theory those concepts,
principles and techniques of analysis, which are concerned with
the decision-making process. These are adapted or modified insuch a way that it enables the manager to take better decisions.
Thus, managerial economics attains the objective of building a
suitable tool kit from traditional economics.
Managerial economics also incorporates useful ideas from otherdisciplines such as psychology, sociology, etc. If they are found
relevant for decision-making. In fact, managerial economics
takes the aid of other academic disciplines that are concernedwith the business decisions of a manager in view of the various
explicit and implicit constraints subject to which resource
allocation is to be optimised.
It helps in reaching a variety of business decisions even in acomplicated environment. Certain examples of such decisions
are those decisions concerned with:
oThe products and services to be produced
o The inputs and production techniques to be used
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o The quantity of output to be produced and the sellingprices to be subscribed
o The best sizes and locations of new plantso
Time of replacing the equipmento Allocation of the available capital
Managerial economics helps a manager to become a morecompetent model builder. Thus, he can pick out the essential
relationships, which characterise a situation and leave out the
other unwanted details and minor relationships.
At the level of the firm, functional specialists or functionaldepartments exist, e.g., finance, marketing, personnel,production etc. For these various functional areas, managerial
economics serves as an integrating agent by co-ordinating the
different areas. It then applies the decisions of each department
or specialist, those implications, which are pertaining to other
functional areas. Thus managerial economics enables business
decision-making to operate not with an inflexible and rigid but
with an integrated perspective. This integration is importantbecause the functional departments or specialists often enjoy
considerable autonomy and achieve conflicting goals.Managerial
economics keeps in mind the interaction between the firm and
society and accomplishes the key role of business as an agent
in attaining social economic welfare. There is a growing
awareness that besides its obligations to shareholders, business
enterprise has certain social obligations as well. Managerialeconomics focuses on these social obligations while taking
business decisions. By doing so, it serves as an instrument of
furthering the economic welfare of the society through socially
oriented business decisions.
Thus, it is evident that the applicability and usefulness of
managerial economics is obtained by performing the following
activates:
Borrowing and adopting the tool-kit from economic theory.
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Incorporating relevant ideas from other disciplines to achievebetter business decisions.
Serving as a catalytic agent in the course of decision-making bydifferent functional departments/specialists at the firms level.
Accomplishing a social purpose by adjusting business decisionsto social obligations.
ECONOMIC THEORY AND MANAGERIAL ECONOMICS
Economic theory offers a variety of concepts and analytical tools that
can assist the manager in the decision-making practices. Problem
solving in business has, however, found that there exists a widedisparity between the economic theory of a firm and actual observed
practice, thus necessitating the use of many skills and be quite useful
to examine two aspects in this regard:
The basic tools of managerial economics which it has borrowedfrom economics, and
The nature and extent of gap between the economic theory ofthe firm and the managerial theory of the firm.
Basic Economic Tools in Managerial Economics
The most significant contribution of economics to managerial
economics lies in certain principles, which are basic to the entire
range of managerial economics. The basic principles may be identified
as follows:
1.Opportunity Cost Principle
The opportunity cost of a decision means the sacrifice of alternatives
required by that decision. This can be best understood with the help
of a few illustrations, which are as follows:
The opportunity cost of the funds employed in ones ownbusiness is equal to the interest that could be earned on those
funds if they were employed in other ventures.
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The opportunity cost of the time as an entrepreneur devotes tohis own business is equal to the salary he could earn by seeking
employment.
The opportunity cost of using a machine to produce one productis equal to the earnings forgone which would have been possible
from other products.
The opportunity cost of using a machine that is useless for anyother purpose is zero since its use requires no sacrifice of other
opportunities.
If a machine can produce either X or Y, the opportunity cost ofproducing a given quantity of X is equal to the quantity of Y,which it would have produced. If that machine can produce 10
units of X or 20 units of Y, the opportunity cost of 1 X is equal
to 2 Y.
If no information is provided about quantities produced, exceptabout their prices then the opportunity cost can be computed in
terms of the ratio of their respective prices, say Px/Py.
The opportunity cost of holding Rs. 500 as cash in hand for oneyear is equal to the 10% rate of interest, which would have been
earned had the money been kept as fixed deposit in a bank.
Thus, it is clear that opportunity costs require the ascertaining
of sacrifices. If a decision involves no sacrifice, its opportunity
cost is nil.
For decision-making, opportunity costs are the only relevant
costs. The opportunity cost principle may be stated as under:The cost involved in any decision consists of the sacrifices of
alternatives required by that decision. If there are no sacrifices, there
is no cost.
Thus in macro sense, the opportunity cost of more guns in an
economy is less butter. That is the expenditure to national fund for
buying armour has cost the nation of losing an opportunity of buying
more butter. Similarly, a continued diversion of funds towards defence
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spending, amounts to a heavy tax on alternative spending required for
growth and development.
2. Incremental PrincipleThe incremental concept is closely related to the marginal costs andmarginal revenues of economic theory. Incremental concept involves
two important activities which are as follows:
Estimating the impact of decision alternatives on costs andrevenues.
Emphasising the changes in total cost and total cost and totalrevenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decision.The two basic components of incremental reasoning are as follows:
Incremental cost: Incremental cost may be defined as thechange in total cost resulting from a particular decision.
Incremental revenue: Incremental revenue means the change intotal revenue resulting from a particular decision.
The incremental principle may be stated as under:
A decision is obviously a profitable one if:o It increases revenue more than costso It decreases some costs to a greater extent than it
increases other costs
o It increases some revenues more than it decreases otherrevenues
o It reduces costs more that revenues.Some businessmen hold the view that to make an overall profit,
they must make a profit on every job. Consequently, they refuse
orders that do not cover full cost (labour, materials and overhead) plus
a provision for profit. Incremental reasoning indicates that this rule
may be inconsistent with profit maximisation in the short run. A
refusal to accept business below full cost may mean rejection of a
possibility of adding more to revenue than cost. The relevant cost is
not the full cost but rather the incremental cost. A simple problem willillustrate this point.
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IIIustration
Suppose a new order is estimated to bring in additional revenue of Rs.
5,000. The costs are estimated as under:
Labour Rs. 1,500Material Rs. 2,000
Overhead (Allocated at 120% of labour cost) Rs. 1,800
Selling administrative expenses
(Allocated at 20% of labour and material cost) Rs. 700
Total Cost Rs. 6,000
The order at first appears to be unprofitable. However, suppose,if there is idle capacity, which can be, utilised to execute this order
then the order can be accepted. If the order adds only Rs. 500 of
overhead (that is, the added use of heat, power and light, the added
wear and tear on machinery, the added costs of supervision, and so
on), Rs. 1,000 by way of labour cost because some of the idle workers
already on the payroll will be deployed without added pay and no
extra selling and administrative cost then the incremental cost ofaccepting the order will be as follows.
Labour Rs. 1,500
Material Rs. 2,000
Overhead Rs. 500
Total Incremental Cost Rs. 3,500
While it appeared in the first instance that the order will resultin a loss of Rs. 1,000, it now appears that it will lead to an addition of
Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does
not mean that the firm should accept all orders at prices, which cover
merely their incremental costs. The acceptance of the Rs. 5,000 order
depends upon the existence of idle capacity and labour that would go
unutilised in the absence of more profitable opportunities. Earleys
study of excellently managed large firms suggests that progressive
corporations do make formal use of incremental analysis. It is,
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however, impossible to generalise on the use of incremental principle,
since the observed behaviour is variable.
3.Principle of Time Perspective
The economic concepts of the long run and the short run have become
part of everyday language. Managerial economists are also concerned
with the short-run and long-run effects of decisions on revenues as
well as on costs. The actual problem in decision-making is to maintain
the right balance between the long-run and short-run considerations.
A decision may be made on the basis of short-run considerations, but
may in the course of time offer long-run repercussions, which make itmore or less profitable than it appeared at first. An illustration will
make this point clear.
IIIustration
Suppose there is a firm with temporary idle capacity. An order for
5,000 units comes to managements attention. The customer is willing
to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.
The short-run incremental cost (ignoring the fixed cost) is only Rs.
3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per
unit (Rs. 5,000 for the lot. However, the long-run repercussions of the
order ought to be taken into account are as follows:
If the management commits itself with too much of business atlower prices or with a small contribution, it may not have
sufficient capacity to take up business with higher
contributions when the opportunity arises. The management
may be compelled to consider the question of expansion of
capacity and in such cases; even the so-called fixed costs may
become variable.
If any particular set of customers come to know about this lowprice, they may demand a similar low price. Such customers
may complain of being treated unfairly and feel discriminated.
In response, they may opt to patronise manufacturers with
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more decent views on pricing. The reduction or prices under
conditions of excess capacity may adversely affect the image of
the company in the minds of its clientele, which will in turn
affect its sales.It is, therefore, important to give due consideration to the time
perspective. The principle of time perspective may be stated as under:
A decision should take into account both the short-run and long-run
effects on revenues and costs and maintain the right balance between
the long-run and short-run perspectives.
Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting pricesbelow full cost though it often experienced idle capacity and the
management was fully aware that the incremental cost was far below
full cost. This was because the management realised that the long-run
repercussions of pricing below full cost would make up for any short-
run gain. The management felt that the reduction in rates for some
customers might have an undesirable effect on customer goodwill
particularly among regular customers not benefiting from price
reductions. It wanted to avoid crating such an image of the firm that
it exploited the market when demand was favorable but which was
willing to negotiate prices downward when demand was unfavorable.
4. Discounting PrincipleOne of the fundamental ideas in economics is that a rupee tomorrow
is worth less than a rupee today. This seems similar to the saying that
a bird in hand is worth two in the bush. A simple example would
make this point clear. Suppose a person is offered a choice to make
between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will
choose the Rs. 100 today.
This is true for two reasons. First, the future is uncertain and
there may be uncertainty in getting Rs. 100 if the present opportunity
is not availed of. Secondly, even if he is sure to receive the gift in
future, todays Rs. 100 can be invested so as to earn interest, say, at 8
percent so that. one year after the Rs. 100 of today will become Rs.
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108 whereas if he does not accept Rs. 100 today, he will get Rs. 100
only in the next year. Naturally, he would prefer the first alternative
because he is likely to gain by Rs. 8 in future. Another way of saying
the same thing is that the value of Rs. 100 after one year is not equalto the value of Rs. 100 of today but less than that. To find out how
much money today is equal to Rs. 100 would earn if one decides to
invest the money. Suppose the rate of interest is 8 percent. Then we
shall have to discount Rs. 100 at 8 per cent in order to ascertain how
much money today will become Rs. 100 one year after. The formula is:
V =
Rs. 100
1 + iwhere,
V = present value
i = rate of interest.
Now, applying the formula, we get
V =
Rs. 100
1 + i
=1001.08
If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,
which will accumulate at 8 per cent after one year.
92.59 x 1.08 = 99.0072
= 1.00
The same reasoning applies to longer periods. A sum of Rs. 100two years from now is worth:
V =
Rs. 100
=
Rs. 100
=
Rs. 100
(1+i)2 (1.08)2 1.1664
Similarly, we can also check by computing how much the
cumulative interest will be after two years. The principle involved in
the above discussion is called the discounting principle and is stated
as follows: If a decision affects costs and revenues at future dates, it
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is necessary to discount those costs and revenues to present values
before a valid comparison of alternatives is possible.
5. Equi-marginal PrincipleThis principle deals with the allocation of the available resource
among the alternative activities. According to this principle, an input
should be allocated in such a way that the value added by the last
unit is the same in all cases. This generalisation is called the equi-
marginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm
is engaged in four activities, which need labour services, viz., A, B, Cand D. It can enhance any one of these activities by adding more
labour but sacrificing in return the cost of other activities. If the value
of the marginal product is higher in one activity than another, then it
should be assumed that an optimum allocation has not been attained.
Hence it would, be profitable to shift labour from low marginal value
activity to high marginal value activity, thus increasing the total value
of all products taken together. For example, if the values of certain two
activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
In this case it will be profitable to shift labour from A to activity
B thereby expanding activity B and reducing activity A. The optimum
will be reach when the value of the marginal product is equal in all the
four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain aspects of the equi-marginal principle need
clarifications, which are as follows:
First, the values of marginal products are net of incrementalcosts. In activity B, we may add one unit of labour with an
increase in physical output of 100 units. Each unit is worth 50
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paise so that the 100 units will sell for Rs. 50. But the increased
output consumes raw materials, fuel and other inputs so that
variable costs in activity B (not counting the labour cost) are
higher. Let us say that the incremental costs are Rs. 30 leavinga net addition of Rs. 20. The value of the marginal product
relevant for our purpose is thus Rs. 20.
Secondly, if the revenues resulting from the addition of labourare to occur in future, these revenues should be discounted
before comparisons in the alternative activities are possible.
Activity A may produce revenue immediately but activities B, C
and D may take 2, 3 and 5 years respectively. Here thediscounting of these revenues will make them equivalent.
Thirdly, the measurement of value of the marginal product mayhave to be corrected if the expansion of an activity requires an
alternative reduction in the prices of the output. If activity B
represents the production of radios and it is not possible to sell
more radios without a reduction in price, it is necessary to make
adjustment for the fall in price. Fourthly, the equi-marginal principle may break under
sociological pressures. For instance, du to inertia, activities are
continued simply because they exist. Similarly, due to their
empire building ambitions, managers may keep on expanding
activities to fulfil their desire for power. Department, which are
already over-budgeted often, use some of their excess resources
to build up propaganda machines (public relations offices) towin additional support. Governmental agencies are more prone
to bureaucratic self-perpetuation and inertia.
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MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES
A managerial economist can play a very important role by assisting
the management in using the increasingly specialised skills and
sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business
concerns, the importance of the managerial economist is therefore
recognised a lot today. In advanced countries like the USA, largecompanies employ one or more economists. In our country too, big
industrial houses have understood the need for managerial
economists. Such business firms like the Tatas, DCM and Hindustan
Lever employ economists. A managerial economist can contribute to
decision-making in business in specific terms. In this connection, two
important questions need be considered:
1.What role does he play in business, that is, what particularmanagement problems lend themselves to solution through
economic analysis?
2. How can the managerial economist best serve management, thatis, what are the responsibilities of a successful managerial
economist?
Role of a Managerial Economist
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One of the principal objectives of any management in its decision-
making process is to determine the key factors, which will influence
the business over the period ahead. In general, these factors can be
divided into two categories: External InternalThe external factors lie outside the control of management
because they are external to the firm and are said to constitute
business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management, and
they are known as business operations. To illustrate, a business firmis free to take decisions about what to invest, where to invest, how
much labour to employ and what to pay for it, how to price its
products, and so on. But all these decisions are taken within the
framework of a particular business environment, and the firms degree
of freedom depends on such factors as the governments economic
policy, the actions of its competitors and the like.
Environmental Studies of a Business Firm
An analysis and forecast of external factors constituting general
business conditions, for example, prices, national income and output,
volume of trade, etc., are of great significance since they affect every
business firm. Certain important relevant factors to be considered in
this connection are as follows:
The outlook for the national economy, the most important local,regional or worldwide economic trends, the nature of phase of
the business cycle that lies immediately ahead.
Population shifts and the resultant ups and downs in regionalpurchasing power.
The demand prospects in new as well as established markets.Impact of changes in social behaviour and fashions, i.e.,
whether they will tend to expand or limit the sales of acompanys products, or possiblymake the products obsolete?
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The areas in which the market and customer opportunities arelikely to expand or contract most rapidly.
Whether overseas markets expand or contract and the affect ofnew foreign government legislations on the operation of theoverseas plants?
Whether the availability and cost of credit tend to increase ordecrease buying, and whether money or credit conditions ahead
are likely to easy or tight?
The prices of raw materials and finished products. Whether the competition will increase or decrease. The main components of the five-year plan, the areas where
outlays have been increased and the segments, which have
suffered a cut in their outlays.
The outlook to governments economic policies and regulationsand changes in defence expenditure, tax rates tariffs and import
restrictions.
Whether the Reserve Banks decisions will stimulate or depressindustrial production and consumer spending and how will
these decisions affect the companys cost, credit, sales and
profits.
Reasonably accurate data regarding these factors can enable the
management to chalk out the scope and direction of their own
business plans effectively. It will also help them to determine the
timing of their specific actions. And it is these factors, which present
some of the areas where a managerial economist can make effectivecontribution. The managerial economist has not only to study the
economic trends at the micro-level but also must interpret their
relevance to the particular industry or firm where he works. He has to
digest the ever-growing economic literature and advise top
management by means of short, business-like practical notes. In
mixed economy like that of India, the managerial economist
pragmatically interprets the intentions of controls and evaluates theirimpact. He acts as a bridge between the government and the industry,
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translating the governments intentions and transmitting the reactions
of the industry. In fact, the government policies emerge out of the
performance of industry, the expectations of the people and political
expediency.
Business Operations
A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in
respect of such problems as price, rate of operations, investment,
expansion or contraction. Certain relevant questions in this context
would be as follows: What will be a reasonable sales and profit budget for the next
year?
What will be the most appropriate production schedules andinventory policies for the next six months?
What changes in wage and price policies should be madenow?
How much cash will be available next month and how shouldit be invested?
Specific Functions
The managerial economists can play a further role, which can cover
the following specific functions as revealed by a survey pertaining to
Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:
Sales forecasting.
Industrial market research. Economic analysis of competing companies. Pricing problems of industry. Capital projects. Production programmes. Security / Investment analysis and forecasts. Advice on trade and public relations.
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Advice on primary commodities. Advice on foreign exchange. Economic analysis of agriculture. Analysis of underdeveloped economics. Environmental forecasting.
The managerial economist has to gather economic data, analyse all
relevant information about the business environment and prepare
position papers on issues facing the firm and the industry. In the case
of industries prone to rapid theological advances, the manager may
have to make continuous assessment of tl1e impact of changing
technology. The manager' may need to evaluate the capital budget in
the light of short and long-range financial, profit and market
potentialities. Very often, he also needs to prepare speeches for the
corporate executives. It is thus clear that in practice, managerial
economists perform many and various functions. However, of all
these, the marketing functions, i.e., sales force listing an industrial
market research, are the most important.
For this purpose, the managers may collect statistical records of
the sales performance of their own business and those rehiring to
their rivals, carry out analysis of these records and report on trends in
demand, their market shares, and the relative efficiency of their retail
outlets. Thus, while carrying out heir functions, the managers may
have to undertake detailed statistical analysis. There are, of course,
differences in the relative importance of the various functions
performed from firm to firm and in the degree of sophistication of the
methods used in performing these functions. But there is no doubt
that the job of a managerial economist requires alertness and the
ability to work uriderpressure.
Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
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economist may also provide general intelligence service. Thus the
economist may supply the management with economic information of
general interest such as competitors
prices and products, tax rates, tariff rates, etc.
Participating in Public Debates
Many well-known business economists participate in public debates.
The government and society alike are seeking their advice and views.
Their practical experience in business and industry adds prestige to
their views. Their public recognition enhances their protg in the
.firm itself.
Indian Context
In the Indian context, a managerial economist is expected to perform
the following functions:
Macro-forecasting for demand and supply.
Production planning at macro and micro levels. Capacity planning and product-mix determination. Economics of various production lines. Economic feasibility of new production lines / processes and
projects.
Assistance in preparation of overall development plans. Preparation of periodical economic reports bearing on various
matters such as the company's product-lines, future growth
opportunities, market pricing situation, general business,. and
various national/international factors affecting industry and
business.
Preparing briefs; speeches, articles and papers for topmanagement for various chambers, Committees, Seminars,
Conferences, etc
Keeping management informed of various national and
International Developments on economic/industrial matters.
With the adoption of the new economic policy, the macro-
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economic environment is changing fast and these changes have
tremendous implications for business. The managerial economists
have to playa much more significant role. They ha'1e to constantly
measure the possibilities of translating the rapidly changing economicscenario into workable business opportunities. As India marches
towards globalisation, the managerial economists will have to interpret
the global economic events and find out how the firm can avail itself of
the various export opportunities or of establishing plants abroad
either wholly owned or in association with local partners.
Responsibilities of a Managerial Economist
Besides considering the opportunities that lie before a managerial
economist it is necessary to take into account the services that are
expected by the management. For this, it is necessary for a
managerial economist to thoroughly recognise the responsibilities
and obligations. A managerial economist can serve the management
best by recognising that the main objective of the business, is to
make a profit on its invested capital. Academic training and the
critical comments from people outside the business may lead a
managerial economist to adopt an apologetic or defensive attitude
towards profits. There should be a strong personal conviction on part
of the managerial economist that profits are essential and it is
necessary to help enhance the ability of the firm to make profits.
Otherwise it is difficult to succeed in serving management.
Most management decisions necessarily concern the future, which
is rather uncertain. It is, therefore, absolutely essential that a
managerial economist recognises his responsibility to make
successful forecast. By making the best possible forecasts and
through constant efforts to improve, a managerial' ng, the risks
involved in uncertainties. This enables the management to follow a
more orderly course of business planning. At times, it is required for
the managerial economist to reassure the management that an
important trend will continue. In other cases, it is necessary to point
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out the probabilities of a turning point in some activity of importance
to management. In any case, managerial economist must be willing to
make fairly positive statements about impending economic
developments. These can be based upon the best possibleinformation and analysis. The management's confidence in a
managerial economist increases more quickly and thoroughly with
a record of successful forecasts, well documented in advance and
modestly evaluated when the actual results become available.
A few consequences to the above proposition need also be
emphasised here.
First, a managerial economist has a major responsibility to alertmanagelI1ent at the earliest possible moment in' case there is an
err6r' in his forecast. This will assist the mallagement in making
appropriate adjustment in policies and programmes and
strengthen his oWn position as a member of the management
team by keeplrighis fingers on the economic pulse of the
business.
Secondly, a managerial economist must establish and maintainmany contacts with individuals and data sources: which would
not be immediately available to the other members of the
management. Extensive familiarity with reference sources and
material is essential. It is still more important that the known
individuals who are specialists in particular fields have a bearing
on tpe managerial economist's work. For this purpose, it is
required that managerial economist joins professional
associations and tak~ active part in them. In fact, one of the best
means of determining the quality of a managerial economist is to
evaluate his ability to obtain information quickly by personal
contacts rather than by lengthy research from either readily
available or obscure reference sources. Within any business,
there' may be a wealth of knowledge and experience but the
managerial economist would be really useful ifit is possible pn
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his part to supplement the existing know-how with additional
information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the
management in successful decision-making and forward planning, it
is necessary'" to able to earn full status on the business team.
Readiness to take up special assignments, be that in study teams,
committees or special projects is another important requirement. This
is because it is necessary for the managerial economist to win
continuing support for himself and his professional ideas. Clarity of
expression and attempting to minimise the use of technical
terminology while communJcating his ideas to management
executives is also an essential role so as to win approval.
To conclude, a managerial economist has a very important role to
play by helping management in successful decision-making and
forward planning. But to discharge his role successfully, it is
necessary to recognise the 'relevant responsibilities and obligations.
To some business executives, however, a managerial economist is still
a luxury or perhaps even a necessary evil. It is not surprising,
therefore, to find that while tneir status is improving and their
impor;ance is gradually rising, managerial economists in certain firms
still 'feel quite insecure. Nevertheless, there is a definite and growing
realisation that they can contribute significantly to the profitable
growth of firms and effective solution oftMir problems, and this'
promises them a positive future.
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LESSON2
DEMAND ANALYSIS
Demand is one of the crucial requirements for the existence of any
business firm. Firms are interested in their profit and sales, both
of which depend partially upon the demand for the product. The
decisions, which management makes with respect to production,
advertising, cost allocation, pricing, inventory holdings, etc. call
for an analysis of demand. While how much a firm can produce
depends upon its capacity and demand for its products. If there is
no demand for a product, its production is unworthy. If demand
falls short of production, one way to balance the two is to create
new demand through more and better advertisements. The more
the future demand for a product, the more inventories the firm
would hold. The larger the demand for a firm's product, the higher
is the price it can charge.
Demand analysis seeks to identify and measure the forces that
determine sales. Once this is done the alternative ways of
manipulating or managing demand can easily be inferred.
Although, demand for a finri's product reflects what the
consumers buy, this can be influenced through manipulating the
factors on which consumers base their demands. Demand
analysis attempts to estiinate the demand for a product in future,
which further helps to plan production based on the estimated
demand.
MEANING OF DEMAND
Demand for a good implies the desire of an individual to acquire the
product. It also includes willingness and ability of ail individual to
pay for the product. For example, a miser's desire for and his ability
to pay for a car is not demand, for he does not have the necessary
will to pay for the car. Similarly, a poor person's desire for and his
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willingness to pay for a car is not demand because he lacks the
necessary purchasing power. One can also imagine an individual,
who possesses both the will and the purchasing power to pay for a
good. But this purchasing power is not the demand for that good,this is because he does not have the desire to buy that product.
Therefore, demand is successful when there are all the three factors:
desire, willingness and ability. It should also be noted that demand
for any goods or services has no meaning unless it is stated with
reference to time, price, competing product, consumer's incomes,
tastes and preferences. This is because demand varies with
fluctuations in these factors. For example, the demand for anAmbassador car in India is 40,000 is meaningless unless it is stated
that this was the demand in 1976 when an Ambassador car's price
was around thirty thousand rupees. The price of the competing cars
prices were around the same, a Bajaj scooter's price was around five
thousand rupees and petrol price was around three and a half
rupees per litre. In 1977, the demand for Ambassador cars could be
different if any of the above factors happened to be different.
Furthermore, it should be noted that a product is defined with
reference to its particular quality. If its quality changes it can be
deemed as another product. Thus, the demand for any product is
the desire, wi1lihigness and ability to buy the product with reference
to a partkular time and given values of variables on which it
depends.
TYPES OF DEMAND
The demand for various kinds of goods is generally classified on the
basis of kinds of consumers, suppliers of goods, nature of goods,
duration of consumption goods, interdependence of demand, period
of demand and nature of use of goods (intermediate or final), The
major classifications of demand are as follows:
Individual and market demand
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Demand for firm's prodtictand industry's products Autonomous and derived demand Demand for durable and non-durable goods Short-term and long-term demand
Individual and Market Demand
The quantity of a product, which an individual is willing to buy at a
particular price during a specific time period, given his money
income, his taste, and prices of other commodities (particularly
substitutes and complements), is called 'individual's demand for a
product'. The total quantity, which all comsumers are willing to buy
at a given price per time unit, given their money income, taste, and
prices of other commodities is known as 'market demand for the
good'. In other words, the market demand for a good is the sum of
the individual demands of all the c6-nsumers of a product, over a
time period at given prices.
Demand for Firm's Product and Industry's ProductsThe quantity of a firm's yield, that can be disposed of at a given price
over a period refers to the demand for firm's product. The aggregate
demand for the product of all firms of an industry is known as the
market-demand or demand for industry's product. This distinction
between the two kinds of demand is not of much use in a highly
competitive market since it merely signifies the distinction between a
sum and its parts. However, where market structure is oligopolistic,a distinction between the demand for firm's product and industry's
product is useful from managerial point of view. The product of each
firm is so differentiated from the products of the rival firms that
consumers treat each product different from the other. This gives
firms an opportunity to plan the price of a product, advertise it in
order to capture a larger market share thereby to enhance profits.
For instance, market of cars, radios, TV sets, refrigerators, scooters,toilet soaps and toothpaste, all belong to this category of markets.
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In case of monopoly and perfect competition, the distinction
between demand for a firm's product and industry's product is not
of much use from managerial point of view. In case of monopoly,
industry is one-firmindustiy andthe demand for firm's product is thesame as that of the industry. In case of perfect competition,
products of all firms .of the industry are homogeneous and price for
each firm is determined by industry. Firms have little opportunity to
plan the prices permissible under local conditions and
advertisement by a firm becomes effective for the whole industry.
Therefore, conceptual distinction between demand for film's product
and industry's product is not much use in business decisionsmaking.
Autonomous and Derived Demand
An Autonomous demand for a product is one that arises
independently of the demand for any other good whereas a derived
demand is one, which is derived from demand of some other good. To
look more closely at the distinction between the two kinds of demand,
consider the demand for commodities, which arise directly from the
biological or physical needs of the human beings, such as demand for
food, clothes and shelter. The demand for these goods is autonomous
demand. Autotnomous demand also arises as a' result of
demonstration effect, rise in income, and increase in population and
advertisement of new produCts. On the other hand, the demand for a
good that arises because of the demand for some other good is called
derived demand. For instance, demand for land, fertiliser and
agricultural tools and implements are derived demand, since the
demand of goods, depends on the demand of food. Similarly, demand
for steel, bricks, cement etc., is a derived demand because it is
derived from the demand for houses and other kind of buildings. [n
general, the demand for, producer goods or industrial inputs is a
derived one. Besides, demand for complementary goods (which
complement the use of other goods) or for supplementary goods
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(which supplement or provide additional utility from the use of other
goods) is a derived demand. For instance petrol is a complementary
goods for automobiles and a chair is a complement to a table.
Consider some examples of supplement goods. Butter is supplementto bread, mattress is supplement to cot and sugar is supplement to
tea. Therefore, demand for petrol, chair, and sugar would be
considered as derived demand. The conceptual distinction between
autonomous demand and derived demand would be useful according
to the point of view of a bllsinessman to the extent the former can
serve as an indicator of the latter.
Demand for Durable and Non-durable Goods
Demand is often classified under demand for durable and non-durable
goods. Durable goods are those goods whose total utility is not
exhausted in single or short-run use. Such goods can be used
continuously over a period of time. Durable goods may be consumer
goods as well as producer goods. Durable consumer goods include
clothes, shoes, house furniture, refrigerators, scooters, and cars. The
durable producer goods include mainly the items under fixed assets,
such as building, plant and machinery, office furniture and fixture.
The durable goods, both consumer and producer goods, may be
further classified as semi-durable goods such as, clothes and
furniture and durable goods such as residential and factory buildings
and cars. On the other harid, non-durable goods are those goods,
which can be used only once such as food items and their total utility
is exhausted in a single use. This category of goods can also be
grouped under non-durable consumer and producer goods. All food
items such as drinks, soap, cooking fuel, gas, kerosene, coal and
cosmetics fall in the former category whereas, goods such as raw
materials', fuel and power, finishing materials and packing items come
in the latter category.
The demand for non-durable goods depends largely on their
current prices, consumers' income and fashion whereas the expected
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price, income and change in technology influence the demand for the
durable good. The demand for durable goods changes over a relatively
longer period. There is another point of distinction between demands
for durable and non-durable goods. Durable goods create demand forreplacement or substitution of the goods whereas non-durable goods
do not. Also the demand for non-durable goods increases or decreases
with a fixed or constant rate whereas the demand for durable goods
increases or decreases exponentially, i.e., it may depend upon some
factors such as obsolescence of machinery, etg. For example, let us
suppose that the annual demand for cigarettes in a city is 10 million
packets and it increases at the rate of half-a-million packets perannum on account of increase in population when other factors
remain constant. Thus, the total demand for cigarettes in the next
year will be 10.5 million packets and 11 million packets in the next to
next year and so on. This is a linear increase in the demand for a non-
durable good like cigarette. Now consider the demand for a durable
good, e.g., automobiles. Let us suppose: (i1 the existing number of
automobiles in a city, in a year is 10,000, (ii) the annual replacement
demand equals 10 per cent of the total demand, and (iii) the annual
autonomous increase in demand is 1000 automobiles. As such, the
total annual clemand for automobiles in four subsequent years is
calculated and presented in Table 2.1.
Table 2.1: Annual Demand for Automobiles
Beginning Total no. of Replacement Annual Total Annualof the ear automobiles demand autonomous demand increase
Stock demand in
, demand1st year 10,000 - - 10,000 -
2nd year 10,000 1000 1000 12,000 2000
-3id year 12,000 1200 1000 14,200 2200
4th year 14,200 1420 1000 16,620 2420
Stock + Replacement + Autonomous demand = TotalDemand
It may be seen from the Table 2.1 that the total demand for
automobiles is increasing at an increasing rate due to acceleration
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in the replacement demand. Another factor, which might accelerate
the demand for automobiles and such durable goods, is the rate of
obsolescence of this category of goods.
Short-term and Long-term Demand
Short-term demand refers to the demand for goods that are demanoed
over a short period. In this category fall mostly the fashion consumer
goods, goods of seasonal use and inferior substitutes during the
scarcity period of superior goods. For instance, the demand for
fashion wears is short-term demand though the demand for the
generic goods such as trousers, shoes and ties continues to remain a
longterm demand. Similarly, demand for umbrella, raincoats,
gumboots, cold drinks and ice creams is of seasonal nature; 'The
demand for such goods lasts till the season lasts. Some goods of this
category are demanded for a very short period, i.e., 1-2 week, for
example, new greeting cards, candles and crackers on occasion of
diwali.
Although some goods are used only seasonally but are durable in
pature, e.g., electric fans, woollen garments, etc. The demand for such
goods is of also durable in nature but it is subject to seasonal
fluctuations. Sometimes, demand for certain gools suddenly increases
because of scarcity of their superior substitutes. For examp1e, when
supply of cooking gas suddenly decreases, demand for kerosene,
cooking coal and charcoal increases. In such cases, additional
demand is of shGrtterm nature. The long-term demand, on the hand,
refers to the demand, which exists over a long-period. The change in
long-term demand is visible only after a long period. Most generic
goods have long-term demand. For example, demand for consumer
and producer goods, durable and non-durable goods, is long-term
demand, though their different varieties or brands may have only
short-term demand. Short-term demand depends, by and large, on the
price of commodities, price of their substitutes, current disposable
income of the consumer, their ability to adjust their consumption
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pattern and their susceptibility to advertisement of a new product.
The long-term demand depends on the long-term income trends,
availability of better substitutes, sales promotion, and consumer
credit facility. The short-term and lcmg-term concepts of demand areuseful in designing new products for established producers, choice of
products for the new entrepreneurs, in pricing policy and in
determining advertisement expenditure.
DETERMIN!\NTS OF MARKET DEMAND
The knowledge of the determinants of market demand for a product
and the nature of relationship between the demand and its
determinants proves very helpful in analysing and estimating demand
for the product. It may be noted at the very outset that a host of
factors determines the demand for a product. In general, following
factors determine market demand for a good:
Price of the good- . Price of the related goods-substitutes, complements and
supplements
Level of consumers' income Consumers' taste and preferenceAdvertisement of the product
Consumers' expectations about future price and supplyposition
Demonstration effect and 'bend-wagon effect
Consumer-credit facility Population of the country Distribution pattern of national income.These factors also include factors such as off-season discounts
and gifts on purchase of a good, level of taxation and general social
and political environment of the country. However, all these factors
are not equally important. Besides, some of them are not
quantifiable. For example, consumer's preferences, utility,demonstration effect and expectations, are difficult to measure.
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However, both quantifiable and non-quantifiable determinants of
demand for a product will be discussed.
1. Price of the Product
The price of a product is one of the most important determinants of
demand in the long run and the only determinant in the short run.
The price and quantity demanded are inversely related to each other.
The law of demand states that the quantity demanded of a good or a
product, which its consumers would like to buy per unit of time,
increases when its price falls, and decreases when its price increases,
provided the other factors remain' same. The assumption 'other
factors remaining same' implies that income of the consumers, prices
of the substitutes and complementary goods, consumer's taste and
preference and number of consumers remain unchanged. The price-
demand relationship assumes a much greater significance in the
oligopolistic market in which outcome of price war between a firm and
its rivals determines the level of success of the firm. The firms have to
be fully aware of price elasticity of demand for their own products and
that of rival firm's goods.
2. Price of the Related Goods or Products
The demand for a good is also affected by the change in the price of
its related goods. The related goods may be the substitutes or
complementary goods.
Substitutes
Two goods are said to. be substitutes of each other if a change in price
of one good affects the deinand for the other in the same direction. For
instance goods X and Y are considered as substitutes for each other if
a rise in the price of X increase demand for Y, and vice versa. Tea and
coffee, hamburgers and hot-dog, alcohol and drugs are some examples
of substitutes in case of consumer goods by definition, the relation
between demand for a product and price of its substitute is of positive
nature. When, price of the substitute of a product (tea) falls (or
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increase), the demand for the product falls (or increases). The
relationship of this nature is shown in Figure 2.1 and 2.2.
Complementary Goods
A good is said to be a complement for another when it complements
the use of the other or when the two goods are used together in such a
way that their demand changes (increases or decreases)
simultaneously. For example, petrol is a complement to car and
scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,
mattress to cot, etc. Two goods are termed as complementary to each
other -i if an increase in the price of one causes a decrease in demand
for the other. By definition, there is an inverse relation between the
demand for a good and the price of its complement. For instance, an
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increase in the price of petrol causes a decrease in the demand for car
and other petrol-run vehicles and vice versa while other thing's
remaining constant. The nature of relationship between the demand
for a product and the price of its complement is given in Figure 2.2.
3. Consume's Income
Income is the basic determinant of market demand since it
determines the purchasing power of a consumer. Therefore, people
with higher current disposable income spend a larger amount on
goods and services than those with lower income. Income-demand
relationship is of more varied nature than that between demand
and its other determinants. While other determinants of demand,
e.g., product's own price and the price ohts substitutes, are more
significant in the short-run, income as a determinant of demand is
equally important in both short run and long run. Before
proceeding further to discuss income-demand relationships, it will
be useful to note that consumer goods of different nature have
different kinds of relationship with consumers having different
levels of income. Hence, the managers need to be fully aware of the
kinds of goods they are dealing with and their relationship with the
income of consumers, particularly about the assessment of both
existing and prospective demand for a product.
For the purpose of income-demand analysis, goods and serv:ices
maybe grouped under four broad categories, which ate: (a) essential
consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige
or luxury goods. To understand all these terms, it is essential to
understand the relationship between income and different kinds of
goods.
Esscntial Consumcr Goods (ECG): The goods and services of this
category are called 'basic needs' and are consumed by all
persons of a society such as food-grains, salt, vegetable oils,
matches, cooking fuel, a minimum clothing and housing.
Quantity demanded for these goods increases with increase in
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consumer's income but only up to certain limit, even though the
total expenditure may increase in accordance with the quality of
goods consumed, other factors remaining the same. The
relationship between goods of this category and consumer'sincome is shown by the curve ECG in Figure 2.3. As the curve
shows, consumer's demand for essential goods increases only
until his income rises to OY2. It tends to saturate beyond this
level of income.
Inferior goods: Inferior goods are those goods whose demand
decreases with the increase in consumer's income. For example
millet is inferior to wheat and rice; bidi (indigenous cigarette) isinferior to cigarette, coarse, textiles are inferior to refined ones,
kerosene is inferior to cooking gas and travelling by bus is
inferior to travelling by taxi. The relation between income and
demand for an inferior good is shown by the curve IG in Figure
2.3 under the assumption that other determinants of demand
remain the same demand for such goods rises only up to a
certain level of income, i.e., OY1 and declines as income
increases beyond this level.
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Normal goods: Normal goods are those goods whose demand increases
with increaseiri the consumer income. For example, clothings,
household furniture and automobiles. The relation between incomeand demand for normal goods is shown by the curve NG in Figure 2.3.
As the curve shows, demand for such goods increases with the
increases in consumer income but at different rates at different levels
of income. Demand for normal goods increases rapidly with the
increase in the consumer's income but slows down with further
increase in income. It should be noted froms Figure 2.3 that up to
certain level of income (YI) the relation between income and demandfor all type of goods is similar. The difference is of only degree. The
relation becomes distinctly different beyond YI level of income.
Therefore, it is important to view the income-demand relations in the
light of the nature of product and the level fconsumer's income.
Prestige and luxury goods: Prestige goods are those goods, which areconsu!TIed mostly by rich section of the society, e.g., precious stones,
antiques, rare paintings, luxury cars and such other items of show-bff.
Whereas luxury goods include jewellery, costly brands of cosmetics, TV
sets, refrigerators, electrical gadgets and cars. Demand for such goods
arises beyond a certain level of consumer's income, i.e., consumption
enters the area of luxury goods. Producers of such goods, while
assessing the demand for their goods, should consider the income
changes in the richer section of the society and not only the per capita
income. The relation between income and demand for such goods isshown by the curve LG in Figure 2.3.
4. Consumer's taste and preference
Consumer's taste and preference play an important role in detennihing
demand for a product. Taste and preference depend, generally, on the
changing. life-style, social customs, religious values attached to a good,
habi of the people, the general levels of living of the society and age and sex
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of the consumers. Change in these factors changes consumer's taste and
preferences. As a result, consumers reduce or give up the consumption of
some goods and add new ones to their consumption pattern. For example,
following the change in fashion, people switch their consumption patternfrom cheaper, old-fashioned goods to costlier mod goods, as long as price
differentials are proportionate with their preferences. Consumers are
prepared to pay higher prices for 'mod goods' even if their virtual utility is
the same as that of old-fashioned goods. The manufacturers of goods and
services that are subject to frequent change in fashion and style, can take
advantage of this situation in two ways: (i) they can make quick profits by
designing new models of their goods and popularising them throughadvertisement, and (ii) they can plan production in abetter way and can
even avoid over-productiorlifthey keep an eye on the changing fashions.
5. Advertisel11ent Expenditure
Advertisement costs are incurred with the objective of increasing the
demand for the goods. This is done in the following ways:
By informing the potential consumers about the availability of thegoods.
By showing its superiority to the rival goods. By influencing consumers' choice against the rival goods, and By setting fashions and changing tastes.The impact of such effects shifts the demand curve upward to the
right.
In other words, when other factors' remain same, the expenditure onadvertisement increases the volume of sales to the same extent. The relation
between advertisement outlay and sales is shown in Figure 2.4.
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Assumptions
Therelatiqnship between demand and advertisement cost as shown in
Figure 2.4 is based on the following assumptions:
Consumers are fairly sensitive and responsive to various modesof advertisement.
The rival firms do not react to the advertisements made by afirm.
The level of demand has not already reached the saturation point.Advertisement beyond this point will make only marginal impact on
demand.
Per unit cost of advertisement added to the price does not make theprice prohibitive for consumers, as compared particularly to the price
of substitutes.
Others determinants of demand, e.g., income and tastes, etc., are notoperating in the reverse direction.
In the absence of these conditions, the advertisement effect on
sales may be unpredictable.
6. Consumers Expectations
Consumers expectations regarding the future prices, income and supply
position of goods play an important role in determining the demand for
goods and services in the short run. If consumers expect a rise in the price
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of a storable good, they would buy more of it at its current price with a view
to avoiding the possibility of price rise future. On the contrary, if consumers
expect a fall in the price of certain goods, they postpone their purchase with
a view to take advantage of lower prices in future, mainly in case of non-essential goods. This behaviour of consumers reduces the current demand
for the goods whose prices are expected to decrease in future. Similarly, an
expected increase in income increases the demand for a product. For
example, announcement of dearness allowance, bonus and revision of pay
scale induces increase in current purchases. Besides, if scarcity of certain
goods is expected by the consumers on account of reported fall in future
production, strikes on a large scale and diversion of civil supplies towardsthe military use causes the current demand for such goods to increase more
if their prices show an upward trend. Consumer demand more for future
consumption and profiteers demand more to make money out of expected
scarcity.
7. Demonstration Effect
When new goods or new models of existing ones appear in the market, rich
people buy them first. For instance, when a new model of car appears in
the market, rich people would mostly be the first buyer, Colour TV sets and
VCRs were first seen in the houses of the rich families some people buy
new goods or new models of goods because they have genuine need for
them. Some others do so because they want to exhibit their affluence. But
once new goods come in fashion, many households buy them not because
they have a genuine need for them but because their neighbors have
bought the same goods. The purchase made by the latter category of the
buyers are made out of such feelings' as jealousy, competition, equality in
the peer group, social inferiority and the desire to raise their social status.
Purchases made on account of these factors are the result of what
economists call 'demonstration effect' or the 'Band-wagon-effect.' These
effects have a positive effect on demand. On the contrary, when goods
become the thing of common use, some people, mostly rich, decrease or
give up the consumption of such goods. This is known as 'Snob Effect'. It
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has a negative effect'on the demand
for the related goods.
8. Consumer-Gredit Facility
Availability of credit to the cansumers fram the sellers, banks, relatians
and friends encourages the conSumers to buy more than what they would
buy in the aosence of credit availability. Therefore, the consumers who can
borrow more can consume more than those who cannot borrow. Credit
facility affects mostly the demand"for durable goods, particularly those,
which require bulk payment at the time of purchase. The car-loan facility
may be one reason why Delhi has more cars than Calcutta, Chennai and
Mumbai. Therefore, the managers who are assessing the prospective
demand for their goods should take into account the availability of credit to
the consumers.
9. Population of the Country
The Jotal domestic demand for a good of mass consumption depends also
on the size' of the population. Therefore, larger the population larger will be
the demand for a product, when price, per capita income, taste and
preference are given. With an increase or decrease in the size of population,
employment percentage remaining the same, demand for the product will
either increase or decrease.
10. Distribution of Na