Managerial Economics Notes1

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NATIONAL OPEN UNIVERSITY OF NIGERIA

COURSE CODE : BHM 303

COURSE TITLE:

MANAGERIAL ECONOMICS

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(THE COURSE GUIDE)

THE NEED

Managerial Economics as a course required for effective resource

management was put in place due to the following developments in the

global business environment:

(a) Growing complexity of business decisionma!ing processes"

(b) #ncreasing need for the use of economic logic$ concept$ theories$ and

tools of economic analysis in the process of decisionma!ing"

(c) %apid increases in the demand for professionally trained managerial

manpower"

&hese developments have made it necessary that every manager aspiring for good leadership and achievement of organi'ational obectives be equipped

with relevant economic principles and applications" nfortunately$ a gap

has been observed in this respect among today*s managers" #t is therefore

the aim of this course to bridge such gap"

THE COURSE OBJECTIVES

+n completion of the requirements of this course$ students and managers

ali!e will be expected to:

1" nderstand the relative importance of Managerial Economics,

-" .now how the application of the principles of managerial economics can

aid in the achievement of business obectives,

/" nderstand the modern managerial decision rules and optimi'ation

techniques,

0" e equipped with tools necessary in the analysis of consumer behaviours$

as well as in forecasting product demand,

2" e equipped with the tools for analy'ing production and costs,

3" nderstand and be able to apply latest pricing strategies,

THE COURSE STRUCTURE

&his course will be presented in modules$ each of which is designed to

achieve specific managerial obectives" #n a nutshell the course contents are

as follows:

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MODULE 1: Basic Principles in the Application of Manaerial

Econo!ics

1.1 Int!"#$t%!n

(a) 4efinition of Managerial Economics

(b) Economic 5nalysis and usiness 4ecisions

(c) 6cope of Managerial Economics

(d) Managerial Economics and Gap between &heory and 7ractice

(e)

1.& O'$t%*+ !, - B#+%n++ F%

1" Meaning and &heories of 7rofit

-" 7rofit maximi'ation as a usiness +bective

/" 6ales$ Growth %ate$ and Maximisation of tility function as business

obectives0" 8ong%un 6urvival$ Mar!et 6hares$ and Entry 7revention

1.3 C!n+t-%n" O/t%%+-t%!n

(a) &he 6ubstitution Method

(b) 8agrangian Multiplier Method

MODULE ": Decision Anal#sis

&.1 Int!"#$t%!n

&.& D$%+%!n An-+%+

1" 9ertainty and ncertainty in 4ecision 5nalysis

-" 5nalysis of the 4ecision 7roblem

/" Expected Monetary alue 4ecision

0" 4ecisionMa!ing #nvolving 6ample #nformation

2" &ime 7erspective in usiness 4ecisions

MODULE 3: An-+%+ !, M-2t D-n" D-n" F#n$t%!n+ D-n"

An-+%+ -n" D-n" F!$-+t%n43.1 Int!"#$t%!n

3.& An-+%+ !, M-2t D-n"

1" 4efinition of Mar!et 4emand

-" &ypes of 4emand

/" 4eterminants of Mar!et 4emand

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3.3 D-n" F#n$t%!n+

1" 8inear 4emand ;unction

-"


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6.3 P%$ Dt%n-t%!n Un" P# M!n!/!

1" Monopoly 7ricing and +utput 4ecision in the 6hort%un

-" Monopoly 7ricing and +utput 4ecision in the 8ong%un

RE9UIRED TET

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UNIT 1: AND IMPORTANCE OF MANAGERIAL

ECONOMICS

C!ntnt

1"> #ntroduction

-"> +bectives

/"> 4efinition and #mportance of Managerial Economics/"1 4efinition of Managerial Economics/"- #mportance of Managerial Economics

/"/ 6cope of Managerial Economics

/"0 Managerial Economics and Gap between &heory and 7ractice/"2 6elf5ssessment Exercise

0"> 9onclusion2"> 6ummary

3"> &utorMar!ed 5ssignment@"> %eferences

1.0 Int!"#$t%!n

&he discovery of managerial economics as a separate course in management studies has been attributed to three maor factors:

/" &he growing complexity of business decisionma!ing processes$ because of changing mar!et conditions and the globali'ation of business transactions"

0" &he increasing use of economic logic$ concepts$ theories$ and tools of economic

analysis in business decisionma!ing processes"

2" %apid increase in demand for professionally trained managerial manpower"

#t should be noted that the recent complexities associated with business decisions hasincreased the need for application of economic concepts$ theories and tools of economic

analysis in business decisions" &he reason has been that ma!ing appropriate businessdecision requires clear understanding of existing mar!et conditions mar!et fundamentalsand the business environment in general" usiness decisionma!ing processes therefore$

requires intensive and extensive analysis of the mar!et conditions in the product$ inputand financial mar!ets" Economic theories$ logic and tools of analysis have been

developed for the analysis and prediction of mar!et behaviours" &he application of economic concepts$ theories$ logic$ and analytical tools in the assessment and prediction

of mar!et conditions and business environment has proved to be a significant help to business decision ma!ers all over the globe"

&.0 O'$t%*+

5t the end of this unit$ you will be expected to:

1" an understanding of the meaning and importance of managerial economics-" the relevant phases in business decision ma!ing processes

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1"

-"

/"

/" familiar with the scope of Managerial Economics0" e able to discuss freely how managerial economics can fill the gap between theoryand practice

3.0 -n" I/!t-n$ !, M-n-4%- E$!n!%$+

3.1 D,%n%t%!n !, M-n-4%- E$!n!%$+

Managerial economics has been generally defined as the study of economic theories$logic and tools of economic analysis$ used in the process of business decision ma!ing" #tinvolves the understanding and use of economic theories and techniques of economic

analysis in analy'ing and solving business problems"

Economic principles contribute significantly towards the performance of managerialduties as well as responsibilities" Managers with some wor!ing !nowledge of economicscan perform their functions more effectively and efficiently than those without such!nowledge"

&a!ing appropriate business decisions requires a good understanding of the technical andenvironmental conditions under which business decisions are ta!en" 5pplication of economic theories and logic to explain and analyse these technical conditions and

business environment can contribute significantly to the rational decisionma!ing

process"

3.& I/!t-n$ !, M-n-4%- E$!n!%$+

#n a nutshell$ three maor contributions of economic theory to business economics have been enumerated:

B&il%in of anal#tical !o%els that help to recogni'e the structure of managerial problems$ eliminate the minor details that can obstruct decision ma!ing$ and help

to concentrate on the main problem area"

Ma(in a,aila-le a set of anal#tical !etho%s for business analyses thereby$enhancing the analytical capabilities of the business analyst"

Clarification of the ,ario&s concepts &se% in -&siness anal#sis) enabling the

managers avoid conceptual pitfalls"

3.&.1 E$!n!%$ An-+%+ -n" B#+%n++ D$%+%!n+

usiness decisionma!ing basically involves the selection of best out of alternativeopportunities open to the business organi'ation" 4ecision ma!ing processes involve four main phases$ including:

Phase One: 4etermining and defining the obective to be achieved"

Phase .+o: 9ollection and analysis of information on economic$ social$

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(c)(d)

(e)

(g)

(h)

political$ and technological environment"

7hase &hree: #nventing$ developing and analy'ing possible course of action

7hase ;our: 6electing a particular course of action from available

alternatives"


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/irst) it can give clear understanding of the various necessary economic concepts$including demand$ supply$ cost$ price$ and the li!e that are used in business analysis"

Secon%) it can help in ascertaining the relevant variables and specifying the relevant data"

;or example$ in deciding what variables need to be considered in estimating the demandfor two different sources of energy$ petrol and electricity"

.hir%) it provides consistency to business analysis and helps in arriving at rightconclusions"

3.3 S$!/ !, M-n-4%- E$!n!%$+

Managerial economics comprises both micro and macroeconomic theories" Generally$the scope of managerial economics extends to those economic concepts$ theories$ andtools of analysis used in analysing the business environment$ and to find solutions to

practical business problems" #n broad terms$ managerial economics is applied economics"

&he areas of business issues to which economic theories can be directly applied is dividedinto two broad categories:

1" +perational or internal issues, and$

-" Environment or external issues"

Operational pro-le!s are of internal nature" &hese problems include all those problemswhich arise within the business organi'ation and fall within the control of management"6ome of the basic internal issues include:

(f) choice of business and the nature of product (what to produce),

(g) choice of si'e of the firm (how much to produce),(h) choice of technology (choosing the factor combination),

(i) choice of price (product pricing),() how to promote sales,

(!) how to face price competition,(l) how to decide on new investments,

(m) how to manage profit and capital, and$(n) how to manage inventory"

&he microeconomic theories dealing with most of these internal issues include$ among

others:0" &he theor# of %e!an%) which explains the consumer behaviour in terms of

decisions on whether or not to buy a commodity and the quantity to be purchased"2" .heor# of Pro%&ction an% pro%&ction %ecisions0 &he theory of production or

theory of the firm explains the relationship between inputs and output"

3" Anal#sis of Mar(et str&ct&re an% Pricin theor#0 7rice theory explains how prices are determined under different mar!et conditions"

@" Profit anal#sis an% profit !anae!ent0 7rofit ma!ing is the most common business obective" ?owever$ ma!ing a satisfactory profit is not always

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guaranteed due to business uncertainties" 7rofit theory guides firms in themeasurement and management of profits$ in ma!ing allowances for the ris! premium$ in calculating the pure return on capital and pure profit$ and for future profit planning"

B" &heory of capital and investment decisions" 9apital is the foundation of any

business" #t efficient allocation and management is one of the most importanttas!s of the managers$ as well as the determinant of the firm*s success level"

6ome of the important issues related to capital include: choice of investment

proect, assessing the efficiency of capital, and$ the most efficient allocation of

capital"

En,iron!ental iss&es are issues related to the general business environment" &hese areissues related to the overall economic$ social$ and political atmosphere of the country inwhich the business is situated" &he factors constituting econo!ic en,iron!ent of a

country include:

1" &he existing economic system-" General trends in production$ income$ employment$ prices$ savings and

investment$ and so on"

/" 6tructure of the financial institutions"

0" Magnitude of and trends in foreign trade"2" &rends in labour and capital mar!ets"3" Government*s economic policies"

@" 6ocial organi'ations$ such as trade unions$ consumers* cooperatives$ and producer unions"

B" &he political environment"C" &he degree of openness of the economy"

Managerial economics is particularly concerned with those economic factors that formthe business climate" #n macroeconomic terms$ managerial economics focus on business

cycles$ economic growth$ and content and logic of some relevant government activities

and policies which form the business environment"

3.5 M-n-4%- E$!n!%$+ -n" G-/ 't;n T7! -n" P-$t%$

.he Gap -et+een .heor# an% Practice

#t is a general !nowledge that there exists a gap between theory and practice in the worldof economic thin!ing and behaviour" y implication$ a theory which appears logically

sound might not be directly applicable in practice" &a!e for instance$ when there areeconomies of scale$ it seems theoretically sound that when inputs are doubled$ output will be more or less doubled$ and when inputs are tripled$ output would be more or less

tripled" &his theoretical conclusion may not hold in practice"

Economic theories are highly simplistic because they are propounded on the basis of economic models based on simplifying assumptions" &hrough economic models$

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economists create a simplified world with its restrictive boundaries from which theyderive their conclusions" 5lthough economic models are said to be an extraction fromthe real world$ the closeness of this extraction depends on how realistic the assumptionsof the model are" #t is a general belief that assumptions of economic models are

unrealistic in most cases" &he most common assumption of the economic models$ as you

may recall$ is the ceteris paribus assumptions (that is all other things being constant or equal)" &his assumption has been alleged to be the most unrealistic assumption"

&hough economic theories are$ no doubt$ hypothetical in nature$ in their abstract formhowever$ they do loo! divorced from reality" 5bstract economic theories cannot besimply applied to real life situations" &his however$ does not mean that economic models

and theories do not serve useful purposes" Microeconomic theory$ for example$

facilitates the understanding of what would be a complicated confusion of billions of facts by constructing simplified models of behaviour that are sufficiently similar to the

actual phenomenon to be of help in understanding them" #t cannot$ nevertheless$ bedenied the fact that there is a gap between economic theory and practice" &he gap arises

from the fact that there exists a gap between the abstract world of economic models andthe real world"

#t suffices to say that although economic theories do not directly offer custommadesolutions to business problems$ they provide a framewor! for logical economic thin!ingand analysis" &he need for such a framewor! arises because the real economic world istoo complex to permit consideration of every bit of economic facts that influence

economic decisions" Economic analysis presents the business decision ma!ers with aroad map, it guides them to their destinations$ and does not ta!e them to their

destinations"

Managerial economics can the gap between theory real world business decisions" &he managerial economic logic and tools of analysis guide businessdecision ma!ers in:

1" identifying their problems in the achievement-" collecting the relevant data and related facts,

/" processing and analysing the facts,0" drawing the relevant conclusions,

2" determining and evaluating the alternative means of achieving the goal,and$

3" ta!ing a decision"

Aithout the application of economic logic and tools of analysis$ business decisions may

li!ely be irrational and arbitrary" #rrationality is highly counterproductive"

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5.0 C!n$#+%!n

&his unit has been able to expose you to what managerial economics is all about and whyit is necessary to have it for effective business decisions" Managerial Economicscomprises both microand macroeconomic theories" #ts scope extends to those economic

concepts$ theories$ and tools of analysis used in the analysis of business environment$ and

to find solutions to practical business problems"

6.0 S#-

&o put some light to the understanding and appreciation of managerial economics as atool of business analysis$ the unit focused on the following issues:

1" Economic analysis and business decisions$ where it was pointed out that businessdecisionma!ing basically involves the selection of best out of alternative opportunities

open to the business enterprise"

-" 6cope of Managerial Economics$ where we learned that the scope of managerialeconomics extends to some economic concepts and tools used in analysing the business

environment in order to see! for solutions to practical business problems"

/" Managerial Economics and the gap between theory and practice$ where it was pointedout that there exists a gap between theory and practice in the world of economic thin!ing

and behaviour" Managerial economics can bridge this gap through logic and tools of analysis that guide business decision ma!ers"

=.0 T#t!8M-2" A++%4nnt

Ahy is the understanding of the principles of Managerial Economics necessary for a business managerD

>.0 R,n$+

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UNIT &: MEANING AND THEORIES OF PROFIT

C!ntnt

1"> #ntroduction

-"> +bectives

/"> &he &heory of 7rofit/"1 &heories of 7rofit

/"- Monopoly 7rofit

/"/ 6elf5ssessment Exercise0"> 9onclusion2"> 6ummary

3"> &utorMar!ed 5ssignment

@"> %eferences

1.0 Int!"#$t%!n

&he term profit means different things to different people" usinesspeople$ accountants$tax collectors$ employees$ and economists have their individual meaning of profit" #n itsgeneral sense$ profit is regarded as income accruing to equity holders$ in the same sense

as wages accrue to the wor!ers, rent accrues to owners of rentable assets, and$ interestaccrues to the money lenders" &o the accountant$ profit* means the excess of revenue

over all paid out costs$ such as manufacturing and overhead expenses" #t is more li!ewhat is referred to a net profit*" ;or practical purposes profit or business income refers

to profit in accounting sense" Economist*s concept of profit is the pure profit or economic profit*" Economic profit is a return over and above the opportunity cost, that

is$ the income expected from the second alternative investment or use of businessresources" this unit$ emphasis will be placed on the various concepts of profit"

&.0 O'$t%*+

y the time you must have gone through this unit$ you will be able to:

1" 4efine profit and differentiate between 5ccounting profit and pure Economic profit"-" familiar with the different theories of profit"/" what is meant by monopoly profit"

3.0 T7 T7!%+ !, P!,%t

efore exposing you to the theories of profit$ it will be helpful for you to distinguish between two often misunderstood profit concepts: the 5ccounting profit and the

Economic profit"

.he Acco&ntin Profit

5ccounting profit may be defined as follows:

5ccounting 7rofit F ∏a F &% (w H r H # H m)

1/


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where &% F &otal %evenue, w F wages and salaries, r F rent, i F interest, and m F cost of materials"

Iou can observe that when calculating accounting profit$ it is only the explicit or boo! costs that are considered and subtracted from the total revenue (&%)"

.he Econo!ic or P&re Profit

nli!e accounting profit$ economic profit ta!es into account both the explicit costs andimplicit or imputed costs" &he implicit or opportunity cost can be defined as the payment

that would be necessary to draw forth the factors of production from their most

remunerative alternative use or employment" Opportunity cost is the income is theincome foregone which the business could expect from the second best alternative use of resources" &he foregone incomes referred to here include interest$ salary$ and rent$ often

called transfer costs0

Economic profit also ma!es provision for (a) insurable ris!s$ (b) depreciation$ (c)necessary minimum payment to shareholders to prevent them from withdrawing their capital investments" Economic profit may therefore be defined as residual left after all

contractual costs$ including the

transfer costs of management$ insurable ris!s$ depreciation$ and payments to shareholdershave been met" &hus$

Economic or 7ure 7rofit F ∏e F &% E9 #9

where E9 F Explicit 9osts, and$ #9 F #mplicit 9osts"


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conditions$ there would be no pure or economic profit and all firms would earn onlymarginal wages$ which is popularly !nown in economics as nor!al profit0

3.1.& C-2@+ Dn-%$ T7!

&he L" " 9lar!*s theory is of the opinion that profits arise in a dynamic economy$ not in a

static economy" 5 static economy is defined as the one in which there is absolutefreedom of competition, population and capital are stationary, production processremains unchanged over time, goods continue to remain homogeneous, there is freedom

of factor mobility, there is no uncertainty and no ris!, and if ris! exists$ it is insurable" #n

a static economy therefore$ firms ma!e only the normal profit* or the wages of management"

5 dynamic economy on the other hand$ is characteri'ed by the following genericchanges:

(i) population increases,

(ii) increase in capital,(iii) improvement in production technique,(iv) changes in the forms of business organi'ations, and$

(v) multiplication of consumer wants"

&he maor functions of entrepreneurs or managers in a dynamic environment are inta!ing advantage of the generic changes and promoting their businesses$ expanding sales$

and reducing costs" &he entrepreneurs who successfully ta!e advantage of changingconditions in a dynamic economy ma!e pure profit"

;rom 9lar!*s point of view$ pure profit exist only in the shortrun" #n the longrun$competition forces other firms to imitate changes made by the leading firms$ leading to a

rise in demand for factors of production" 9onsequently$ production rise$ thus

reducing profits$ especially when revenue remains unchanged"

3.1.3 H-;@+ R%+2 T7! !, P!,%t

&he ris! theory of profit was initiated by ;" " ?awley in 1BC/" 5ccording to ?awley$ris! in business may arise due to such reasons as obsolescence of a product$ sudden fall inthe mar!et prices$ nonavailability of crucial raw materials$ introduction of better

substitutes by competitors$ ris! due to fire$ war and the li!e" %is! ta!ing is regarded as an

inevitable accompaniment of dynamic production$ and those who ta!e ris! have a soundclaim of a separate reward$ referred to as profit*" ?awley simply refers to profit as the price paid by society for assuming business ris!" ?e suggests that businesspeople wouldnot assume ris! without expecting adequate compensation in excess of actuarial value$

that is$ premium on calculable ris!"

3.1.5 n%47t@+ T7! !, P!,%t

;ran! .night treated profit as a residual return to uncertainty bearing$ not to ris! bearing

as in the case of ?awley*s" .night divided ris! into calculable and noncalculable ris!s"

9alculable ris!s are those ris!s whose probability of occurrence can be statisticallyestimated on the basis of available data" Examples of these types of ris!s are ris!s due to

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fire$ theft$ accidents$ and the li!e" 9alculable ris!s are insurable" &hose areas of ris! inwhich the probability of its occurrence is noncalculable$ such as certain elements of production cost that cannot be accurately calculated$ are not insurable"

3.1.6 S$7#/t@+ Inn!*-t%!n T7! !, P!,%t

&he innovation theory of profit was developed by Loseph 5" 6chumpeter" 6chumpeter was of the opinion that factors such as emergence of interest and profits$ recurrence of trade cycles are only incidental to a distinct process of economic development, and

certain principles which could explain the process of economic development would also

explain these economic variables or factors" 6chumpeter*s theory of profit is thusembedded in his theory of economic growth"

#n his explanation of the process of economic growth$ 6chumpeter began with the state of stationary equilibrium$ characterised by equilibrium in all spheres" nder conditions of

stationary equilibrium$ total receipts from the business are exactly equal to the total cost

outlay$ and there is no profit" 5ccording to the 6chumpeter*s theory$ profit can be madeonly by introducing innovations in manufacturing technique$ as well as in the methods of supplying the goods" of innovation include:

1" #ntroduction of new commodity or a better quality good,-" #ntroduction of new method of production,

/" +pening of a new mar!et,

0" 4iscovery of new sources of raw material, and$2" +rganising the industry in an innovative manner with the new techniques"

3.& M!n!/! P!,%t

+bserve that the profit theories presented above were propounded in the bac!ground of the existence of perfect competition" ut as conceived in the theoretical models$ perfect

competition is either nonexistent or is a rare phenomenon" 5n extreme opposite of

perfect competition is the existence of monopoly in the mar!et" &he term monopolycharacterises a mar!et situation in which there is a single seller of a commodity that doesnot have close substitutes"

Monopoly arises due to such factors as:(i) economies of scale,(ii) sole ownership,

(iii) legal sanction and protection, and$(iv) mergers and acquisition"

5 monopolist can earn pure or monopoly* profit and maintain it in the long run by using

its monopoly powers$ including:(i) powers to control price and supply,(ii) powers to prevent entry of competitors by price cutting, and$(iii) monopoly power in certain input mar!ets"

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3.3 S,8A++++nt E.0 R,n$+

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UNIT 3: PROFIT MAIMISATION AS A BUSINESS OBJECTIVE

C!ntnt

1"> #ntroduction

-"> +bectives

/"> 7rofit Maximisation +bective/"1 &he 7rofitMaximising 9onditions

/"- 6elf5ssessment Exercise

0"> 9onclusion2"> 6ummary3"> &utorMar!ed 5ssignment

@"> %eferences

1.0 Int!"#$t%!n

&he conventional economic theory assumes that profit maximisation is the only obectiveof business firms" 7rofit maximisation forms the basis of conventional price theory" #t is

the most reasonable$ analytical$ and productive* business obective" &his unit begins byfamiliari'ing you with the necessary and sufficient conditions for profit maximisation$followed by in depth presentations and business examples"

&.0 O'$t%*+5t the end of this unit$ you will be expected to:

1" the reason a firm sets its obective to be that of profit maximisation

-" the necessary and sufficient conditions for profit maximisation"/" problems involving profit maximisation"

3.0 M-


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revenue obtained from the production and sale of one additional unit of output$ whilemarginal cost* is the cost arising from the production of the one additional unit of output"

&he secon%2or%er con%ition requires that the firstorder condition must be satisfied under the condition of decreasing marginal revenue (M%) and increasing marginal cost (M9)"

;ulfillment of this two conditions ma!es the secondorder condition the sufficient condition for profit maximi'ations"&he firstand secondorder conditions can be illustrated as in figure /"1 below:

F%4# 3.1: M-4%n- C!n"%t%!n+ !, P!,%t M-d d d

Iou can observe that this condition holds only when:

d&% F d&9

(/"1"/)

d d

or

1C


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M% F M9"&o get the secondorder condition$ we ta!e the second derivative of the profit function toget:

d-∏ F d-&% d-&9

d- d- d-

(/"1"0)

&he secondorder condition requires that equation (/"1"0) is negative$ so that:

d-&% d-&9 O >d- d-

or

d-&% O d-&9 (/"1"2)d- d-

Equation (/"1"2) may also be written as:

6lope of M% O 6lope of M9$

since the lefthand side of equation (/"1"2) represents the slope of M% and the righthandside represents the slope of M9"

&his implies that at the optimum point of profit maximisation$ marginal cost (M9) mustintersect the marginal revenue (M%) from below"

Ae conclude that maximum profit occurs where the first and secondorder conditions

are satisfied"

E> -&hen$ &% F 7 F (1>> -)

F 1>> --

(/"1"3)

(/"1"@)

6uppose also that the total cost of producing this commodity is defined by the costfunction:

&9 F 1>> H >"2- (/"1"B)Iou are required to apply the firstorder condition for profit maximisation and determine

the profitmaximising level of output"

5ccording to the firstorder condition$ profit is maximi'ed where:

M% F M9$

->


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+r

d&% F d&9d d

Given equations (/"1"@) and (/"1"B)$ we get:

M% F d&% F 1>> 0d

M9 F d&9 F 1 F d

#t follows that profit is maximi'ed where:M% F M9

+r

1>> 0 F

(/"1"C)

(/"1"1>)

(/"1"11)

6olving for in equation (/"1"11)$ we get:

1>> F 22 F 1>> F 1>>P2 F ->"

&he output level of -> units satisfies the firstorder condition" 8et us see if it satisfies the

secondorder condition"

%ecall that the secondorder condition requires that:

d-&% d-&9 O >d- d-

or

dM% dM9 O >d d

or

d(1>> 0) d() O >d d

0 1 F 2 O >

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&hus the secondorder condition is also satisfied at the output level of -> units"therefore conclude that the profitmaximising level of output in this problem is -> units"

&o determine the maximum profit$ you will substitute -> for in the original profit

function" &hus$ the maximum profit will be:

∏∗ &% &9

F 1>> -- (1> H >"2-)

F 1>> -"2- 1>

F 1>>(->) -"2(->)- 1>

F ->>> 1>>> 1>

F CC>"

Ae conclude that the maximum profit is only"

3.& S,8A++++nt E


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-"4etermine the costminimising level of output

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C!ntnt

1"> #ntroduction

-"> +bectives/"> +ther %elevant usiness +bectives

/"1 6ales$ Growth %ate$ and Maximisation of tility ;unction asusiness +bectives

/"- 6elf5ssessment Exercise0"> 9onclusion

2"> 6ummary


1.0 Int!"#$t%!n

5part from profit maximisation$ as you all !now$ business firms have the followingobectives:

1" Maximisation of 6ales revenue

-" Maximisation of the growth rate

/" Maximisation of manager*s utility function0" Ma!ing satisfactory rate of profit2" 8ongrun survival of the firm

3" Entryprevention and ris!avoidance"

#n this unit$ we discuss these other business obectives with the aim of acquainting youwith the several reasons an entrepreneur will choose to be in business"

&.0 O'$t%*+

?aving gone through this unit$ you will be able to:1" more informed on obectives of a business organisation

-" the techniques of maximising revenue$ output$ and minimising costs/" able to ma!e effective decisions for business expansion and growth"

3.0 R*-nt B#+%n++ O'$t%*+

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/irst) salary and other monetary benefits of managers tend to be more closely related tosales revenue than to profits"

Secon%) ban!s and other financial institutions loo! at sales revenue while financing

business ventures"

.hir%) trend in sales revenue is a readily available indicator of a firm*s performance"

/o&rth) increasing sales revenue enhances manager*s prestige while profits go to the business owners"

/ifth) managers find profit maximisation a difficult obective to fulfill consistently over time and at the same level" 7rofits fluctuate with changing economic conditions"

/inall#) growing sales tend to strengthen competitive spirit of the firm in the mar!et$ andvice versa.

3.1.2 Technique of Total Revenue Maximisation As noted earlier, total revenue (TR) can be defined by

TR = PQ (3.1.1)

where P refers to unit rice and Q refers to !uantity sold.

The oti"isation roble" here is to find the value of Q that "a#i"ises totalrevenue.

The rule for "a#i"isin$ total revenue is that total revenue will be "a#i"i%ed atthe level of sales (Q) for which "ar$inal(&R) = '. n other words, the revenue fro" the sale of the "ar$inal unit of theroduct "ust be e!ual to %ero at the oint of "a#i"u" revenue.

The "ar$inal revenue (&R) is the first derivative of the total revenue (TR)function. or e#a"le, we want to find the level of Q for which revenue will be"a#i"i%ed if the rice function is $iven by*

P = +'' +QThen by e!uation (3.1.1),

TR = PQ = (+'' +Q)Q

= +''Q +Q-

&ar$inal revenue (&R) = dTR = +'' 1'Q

(3.1.-)

(3.1.3)

(3.1.)dQ

-2


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/ettin$ e!uation (3.1.) e!ual to %ero accordin$ to the rule, we $et*

+'' 1'Q = ' (3.1.+)

solvin$ for Q in e!uation (3.1.+), we $et*+'' = 1'Q

or, 1' Q = +''

Q = +'.

This indicates that the revenue0"a#i"isin$ level of outut is +' units.

The "a#i"u" total revenue can be obtained by substitutin$ +' for Q in the totalrevenue function,

TR = +''Q +Q-

Thus, TR = +''(+') +(+')-

= -+,''' 1-,+''

= 1-,+''.

3.1.3 Technique of Output Maximisation: Minimisation of Average Cost

The oti"u" si%e of the fir" is the si%e "ini"ises the avera$e cost of roduction. This is also referred to as the "ost efficient si%e of the fir".2nowled$e of the oti"u" si%e of a fir" is very i"ortant for future lannin$under three i"ortant conditions*

First, a businesserson lannin$ to set u a new roduction unit would lie tonow the oti"u" si%e of the lant for future lannin$. This issue arisesbecause, as the theory of roduction indicates, the avera$e cost of roduction in"ost roductive activities decreases to a certain level of outut and then be$insto increase.

Second, the fir"s lannin$ to e#and their scale of roduction would lie tonow the "ost efficient level of the econo"ies of scale so that they can be ableto lan the "aretin$ of the roduct accordin$ly.

Third, businesseole worin$ under co"etitive business environ"ent arefaced with a $iven "aret rice. Their rofit therefore, deends on their ability toreduce their unit cost of roduction. And, $iven the technolo$y and inut rices,

-3


27/131

the rosect of reducin$ unit cost of roduction deends on the si%e of roduction. The roble" decision "aers face under this condition is how to findthe oti"u" level of outut or the level of outut that "ini"ises the avera$e costof roduction.

As i"lied earlier, under $eneral roduction conditions, the oti"u" level of outut is the one that "ini"ises the avera$e cost (A4), where the avera$e costcan be defined as the ratio between total cost (T4) and !uantity roduced (Q).Thus,

A4 = T4Q

/uose the total cost function of a fir" is $iven by*

T4 = 1'' 5 6'Q 5 Q-then,

A4 = T4 = 1'' 5 6'Q 5 Q-

(3.1.6)

(3.1.7)

Q Q

= 1'' 5 6' 5 Q (3.1.8)Q

The roble" here is to find the value of Q that "ini"ises the avera$e cost, asreresented in e!uation (3.1.8).

The Minimisation Rule. 9ie the "a#i"isation rule, the "ini"i%ation rule is thatthe derivative of the function to be "ini"ised "ust be e!ual to %ero. t followsthat the value the value of outut (Q) that "ini"ises avera$e cost (A4) can beobtained by tain$ the first derivative of the A4 function and settin$ it e!ual to%ero and solvin$ for Q.

Thus, in the current e#a"le,

dA4 = d(1''Q01 5 6' 5 Q) = 01'' 5 (3.1.:)dQ dQ Q-

/ettin$ e!uation (-.3.:) e!ual to %ero, we $et*

01'';Q- 5 = '

01'';Q- = 0

0Q- = 01''

Q- = 1''; = -+

-@


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Q =


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." A" %othschild proposed the hypothesis of longrun survival and mar!etshare goals"5ccording to the hypothesis$ the primary goal of the firm is longrun survival" +ther economists suggest that attainment and retention of a constant mar!et share is anadditional obective of the firms" Managers therefore$ see! to secure their mar!et share

and longrun survival" &he firms may see! to maximise their longrun profit$ which may

not be certain"

3.1.> Ent8/*nt%!n -n" R%+28-*!%"-n$ -+ B#+%n++ O'$t%*

+ther alternative obectives of business firms as suggested by economists are the

prevention of entry of new firms and ris! avoidance" #t is argued that the motive behindentryprevention may be any or all of the followings:

(a) profit maximisation in the longrun,

(b) securing a constant mar!et share, and$(c) avoidance of ris! caused by unpredictable behaviour of new firms"

&he advocates of profit maximisation as business obective argue$ however$ that only profitmaximising firms can survive in the longrun" can achieve all other subsidiary obectives and goals easily only if they can maximise their profits"

5nother argument is that prevention of entry may be the maor obective in the pricing policy of the firm$ particularly in the case of limit pricing" the motive behind entry

prevention is to secure a constant share in the mar!et$ which is compatible with profitmaximisation"

3.& S,8A++++nt E


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&his unit stress the point that managers often set their personal goals different from profit maximisation$ the goal usually pursued by business owners" 6ome good examplesof such manager obectives are sales$ growth rate$ and maximisation of utility function"&he factors explaining this include the fact that:

/irst) salary and other monetary benefits of managers tend to be more closely related tosales revenue than to profits"

Secon%) ban!s and other financial institutions loo! at sales revenue while financing business ventures"

.hir%) trend in sales revenue is a readily available indicator of a firm*s performance"

/o&rth) increasing sales revenue enhances manager*s prestige while profits go to the business owners"

/ifth) managers find profit maximisation a difficult obective to fulfill consistently over time and at the same level" 7rofits fluctuate with changing economic conditions"

/inall#) growing sales tend to strengthen competitive spirit of the firm in the mar!et$ andvice versa.

+ther similar obectives include: ma!ing satisfactory profit rate$ longrun survival of thefirm$ and entryprevention and ris!avoidance" .nowledge of these other businessobectives is essential for management decisions"

=. T#t!8M-2" A++%4nnt+

5part from the business obectives discussed in this unit$ can you enumerate and discuss

briefly other business obectives you can thin! ofD

>.

4wivedi$ 4" +bectives/"> &he 9onstrained +ptimisation &echniques

/>


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/"1 9onstrained +ptimisation by 6ubstitution Method/"- 9onstrained +ptimisation by 8agrangian Multiplier Method/"/ 6elf5ssessment Exercise0"> 9onclusion

2"> 6ummary


1.0 Int!"#$t%!n

&he maximisation and minimi'ation techniques as referred to and discussed the previous units are generally referred to in economics as &nconstraine% optimisation or

minimisation$ as the case may be" are unconstrained in the sense that firms are

assumed to operate under no constraints on their activities" #n the real business worldhowever$ firms face serious resource constraints" &hey need$ for example$ to maximise

output with given quantity of capital and labour time" &he techniques used to optimisethe business obective(s) under constraints are referred to as constraine% opti!isation

techni3&es0 &he three common techniques of optimisation include: 4i5 Linear

Prora!!in) 4ii5 constraine% opti!isation -# s&-stit&tion) and

4iii5 Laranian !&ltiplier0 &he linear programming technique has a wide range of

applications and should be a subect in itself$ usually discussed in detail under

quantitative techniques in economics" &his discussion will attempt to summarise the twoother important techniques$ that is$ constrained optimisation by substitution and8agrangian multiplier"

&.0 O'$t%*+

5t the end of this unit$ you will be expected to:

1" nderstand the meaning and importance of constrained optimisation-" the applicable techniques in constrained optimisation/" able to apply optimisation principles in business decisions

3.0 T7 C!n+t-%n" O/t%%+-t%!n T$7n%#+

&here are basically two mostly used optimisation techniques including: the substitutionmethod, and$ the 8agrangian multiplier method

3.1 C!n+t-%n" O/t%%+-t%!n ' S#'+t%t#t%!n Mt7!"&his technique will be illustrated in two ways: (i) constrained profit maximisation

problem$ and (ii) constrained cost minimisation problems"

3.1.1 C!n+t-%n" P!,%t M->Q -Q- QI H 1B>I 0I- (/"1"1)

Ahere Q and I represent two products"

/1


32/131

Ae wish to maximise equation (/"1"1) subect to the constraint that the sum of the outputof Q and I be equal to /> units" &hat is$

Q H I F /> (/"1"-)

6olving by the substitution method$ we obtain as follows:

;irst note that the process of the substitution method involves two steps1" express one of the variables (Q or I in this case) in terms of the other and solve

the constraint equation for one of them (Q or I)$ and

-" substitute the solution obtained into the obective function (that is$ the function to

be maximi'ed or the profit function) and solve the outcome for the other variable"

S!#t%!n

Given the constraint equation /"1"-)$ we solve for the values of Q and I in terms of one

another to obtain:

Q F /> I

+r

I F /> Q

y substituting the value of Q into the profit equation (/"1"1)$ we obtain:

∏ F 1>>(/> I) -(/> I)- (/> I)I H 1B>I 0I-F />>> 1>>I -(C>> 3>I H I-) />I H I- H 1B>I 0I-

F />>> 1>>I 1B>> H 1->I -I- />I H I- H 1B>I 0I-

F 1->> H 1@>I 2I- (/"1"/)

Equation (/"1"/) can now be maximised by obtaining the first derivative and setting itequal to 'ero and solving for I:

d∏ F 1@> 1>I F >dI

(/"1"0)

6olving equation (/"1"0) for I$ we get:

1>I F 1@>

I F 1@"

6ubstituting 1@ for I into the constraint equation (/"1"-)$ we get:

Q H 1@ F />

/-


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Q F 1/

#t follows that the optimum solution for the constrained profit maximisation problem is QF 1/ units and I F 1@ units" values of Q and I satisfy the constraint" Expressed

differently$ the firm maximises profit by producing and selling 1/ units of product Q and1@ units of product I"

&he maximum profit under the given constraint can now be obtained by substituting theabove values of Q and I into the profit function$ equation (/"1"1):

∏(Ξ, I) F ∏(13, 1@) F 1>>(1/) -(1/)- (1/)(1@) H 1B>(1@) 0(1@)-F -$302"

&hus$ the maximum profit under constraint is


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d9 F 1B> H 1-I F > (/"1"C)dI

6olving for I in equation (/"1"C)$ we get the value of I as follows:

1-I F 1B>I F 12

6ubstituting this value into the constraint equation (/"1"3)$ you get:Q H 12 F /3

Q F -1

&hus$ the optimum solution demands that -1 units of Q and 12 units of I minimise thecost of meeting the combined order of /3 units (that is$ -1 H 12 F /3 units)"minimum cost of producing -1 units of Q and 12 units of I can be obtained as follows$

using equation (/"1"2)$ the obective function:

Minimum 9ost F -Q- QI H /I-

F -(-1)- (-1)(12) H /(12)-

F BB- /12 H 3@2

F 1$-0-

&hus$ the minimum cost of producing the combined order is


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&he 8agrangian function is formulated simply by:;irst$ setting the constraint equation (/"-"-) equal to 'ero:

Q H I /> F >

6econd$ multiplying the resulting equation by (Gree! letter$ JlambdaK):

(Ξ H I />)"

5dding this to the obective function$ we get the 8agrangian function as:

R F 1>>Q -Q- QI H 1B>I 0I- H (Ξ H I />) (/"-"/)

Equation (/"-"/) is the 8agrangian function with three un!nowns$ Q$ I$ and .values of these un!nowns that maximise R will also maximi'e 7rofit (N)" Gree!

letter$ , is referred to as the 8agrangian multiplier" #t measures the impact of a small

change in the constraint on the obective functions"

Ae are now required to maximise R (equation (/"-"/)" do this$ we first obtain the

partial derivatives of R with respect to Q$ I$ and and set each equal to 'ero to satisfythe firstorder condition for optimisation" &his will give rise to a simultaneous equation

system in three un!nowns$ Q$ I$ and as indicated below:

R F 1>>Q -Q- QI H 1B>I 0I- H (Ξ H I />)

R F 1>> 0Q I H F >Ξ

R F Q H1B> BI H F >Ψ

(/"-"0)

(/"-"2)

R F Q H I /> F > (/"-"3)6olving for Q$ I$ and in the above simultaneous equation system$ you obtain the valuesof Q$ I$ and that maximise the obective function in equation (/"-"1)" sing thenecessary technique of solving simultaneous equation systems$ you obtain the solutions:Q F 1/

I F 1@$ and$

F /1"

&he value of implies that if output is increased by 1 unit$ that is$ from /> to /1 units$ profit will increase by about to -C units$ profitwill decrease by about


36/131

6uppose a firm has to supply a combined order of 2>> units of products Q and I" oint cost function for the two products is given by:

9 F 1>>Q- H 12>I- (/"-"@)

6ince the quantities to be produced of Q and I are not specified in the order$ the firm isfree to supply Q and I in any combination" &he problem is therefore$ to find thecombination of Q and I that minimises cost of production$ subect to the constraint$ Q H

I F 2>>" we are required to:

Minimise 9 F 1>>Q- H 12>I-

6ubect to Q H I F 2>> (/"-"B)

&he 8agrangian function can be formulated as in equation (/"-"C) below:

Rc F 1>>Q- H 12>I- H (500 Q I)

5s before$ the firstorder partial derivatives yield:

Rc F ->>Q F >Ξ

Rc F />>I F >Ψ

Rc F 2>> Q I F >

(/"-"C)

(/"-"1>)

(/"-"11)

(/"-"1-)

5gain$ solving the above simultaneous equations for Q$ I$ and , we get the solution tothe cost minimisation problem"

;or simplicity$ substract equation (/"-"11) from equation (/"-"1>)$ you get:

->>Q (/>>I ) F >

->>Q />>I F >

->>Q F />>I

Q F 1"2I (/"-"1/)

6ubstituting 1"2I for Q in equation (/"-"1-)$ we get:

2>> 1"2I I F >

2>> -"2I F >

/3


37/131

-"2I F 2>>

I F ->>

6ubstituting I F ->> into the constraint equation (/"-"B)$ you get:

Q H ->> F 2>>

Q F />>"

#t follows that the solution to the minimisation problem is that Q F />> and I F ->> willminimise the cost of producing the combined 2>> units of the products Q and I"

&he minimum cost is obtained by using the obective function (equation (/"-"@)) asfollows:

9 F 1>>Q- H 12>I-

F 1>>(/>>)- H 12>(->>)-

F C$>>>$>>> H 3$>>>$>>>

F 12$>>>$>>>

&hus the minimum cost of supplying the combined 2>> units of products Q and I is


38/131

quantitative techniques in economics" &his unit has attempted to outline the two other important techniques$ that is$ constrained optimisation by substitution and 8agrangianmultiplier" oth techniques were illustrated by profit maximisation and costminimisation problems" nder the 8angrangian method$ a very important multiplier$ the

8angrangian multiplier$ S$ was introduced" &he value of S would imply that if a business

firm increases output by 1 unit$ all things being equal$ profit will increase by units$ that maximises profit" se the 8agrangian multiplier method"

>.0 R,n$+

1" 4wivedi$ +bectives/"> 4ecision 5nalysis

/B


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1"

-"/"

0"

2"

/"1 9ertainty and ncertainty in 4ecision 5nalysis/"- 5nalysis of the 4ecision 7roblem/"/ 6elf5ssessment Exercise0"> 9onclusion

2"> 6ummary


1.0 Int!"#$t%!necision analysis is the "odern aroach to decision "ain$ both in econo"icsand in business. t can be defined as the lo$ical and !uantitative analysis of allthe factors influencin$ a decision. The analysis forces decision "aers toassu"e so"e active roles in the decision0"ain$ rocess. >y so doin$, they rely"ore on rules that are consistent with their lo$ic and ersonal behaviour than onthe "echanical use of a set of for"ulas and tabulated robabilities.

The ri"ary ai" of decision analysis is to increase the lielihood of $oodoutco"es by "ain$ $ood and effective decisions. A $ood decision "ust beconsistent with the infor"ation and references of the decision "aer. t followsthat decision analysis rovides decision0"ain$ fra"ewor based on availableinfor"ation on the business environ"ent, be it a sa"le infor"ation, ?ud$"entalinfor"ation, or a co"bination of both.

5s you may have noticed in unit 2$ optimisation techniques are regarded as the mostimportant techniques in the managerial decisionma!ing processes" optimisation

technique is generally defined as the technique used in finding the value of the

independent variable(s) that maximises or minimises the value of the dependent variable"

&.0 O'$t%*+

5t the end of this unit$ you will be able to:

nderstand what decision analysis is all about.now how you can ma!e business decisions under conditions of uncertainty5nalyse decision problems with a view to providing solutions"se sample information in ma!ing business and economic decisions

e informed about time perspective in business decisions"

3. !ecision Anal"sis&ost decision0"ain$ situations involve the choice of one a"on$ several

alternatives actions. The alternative actions and their corresondin$ ayoffs areusually nown to the decision0"aer in advance. A rosective investor choosin$ one invest"ent fro" several alternative invest"ent oortunities, astore owner deter"inin$ how "any of a certain tye of co""odity to stoc, and aco"any e#ecutive "ain$ caital0bud$etin$ decisions are so"e e#a"les of abusiness decision "aer selectin$ fro" a "ultitude of a "ultitude of alternatives.The decision "aer however, does not now which alternative which alternative

/C


40/131

will be best in each case, unless he;she also nows with certainty the values of the econo"ic variables that affect rofit. These econo"ic variables are referredto, in decision analysis, as states of nature as they reresent different events that"ay occur, over which the decision "aer has no control.

The states of nature in decision roble"s are $enerally denoted by si

(i = 1, -, 3,@, ), where is the nu"ber of or different states of nature in a $iven businessand econo"ic environ"ent. t is assu"ed here that the states of nature are"utually e#clusive, so that no two states can be in effect at the sa"e ti"e, andcollectively e#haustive, so that all ossible states are included within the decisionanalysis.

The alternatives available to the decision "aer are denoted byai (i = 1, -, 3, @, n), where n is the nu"ber of available alternatives. t is also$enerally assu"ed that the alternatives constitute a "utually e#clusive,collectively e#haustive set.

3.1 Certaint" an# $ncertaint" in !ecision Anal"sishen the state if nature, si, whether nown or unnown, has no influence on theoutco"es of $iven alternatives, we say that the decision "aer is oeratin$under certainty. Btherwise, he;she is oeratin$ under uncertainty.

ecision "ain$ under certainty aears to be si"ler than that under uncertainty. Cnder certainty, the decision "aer si"ly araises the outco"eof each alternative and selects the one that best "eets his;her ob?ective. f thenu"ber of alternatives is very hi$h however, even in the absence of uncertainty,the best alternative "ay be difficult to identify. 4onsider, for e#a"le, theroble" of a delivery a$ent who "ust "ae 1'' deliveries to different residencesscattered over 9a$os "etroolis. There "ay literally be thousands of differentalternative routes the a$ent could choose. Dowever, if the a$ent had only 3stos to "ae, he;she could easily find the least0cost route.

ecision "ain$ under uncertainty is always co"licated. t is the robabilitytheory and "athe"atical e#ectations that offer tools for establishin$ lo$icalrocedures for selectin$ the best decision alternatives. Thou$h statisticsrovides the structure for reachin$ the decision, the decision "aer has to in?ecthis;her intuition and nowled$e of the roble" into the decision0"ain$fra"ewor to arrive at the decision that is both theoretically ?ustifiable andintuitively aealin$. A $ood theoretical fra"ewor and co""onsense aroach

are both essential in$redients for decision "ain$ under uncertainty.To understand these concets, consider an investor wishin$ to invest 1'','''in one of three ossible invest"ent alternatives, A, >, and 4. nvest"ent A is a/avin$s Plan with returns of 6 ercent annual interest. nvest"ent > is a$overn"ent bond with .+ ercent annual interest. nvest"ents A and > involveno riss. nvest"ent 4 consists of shares of "utual fund with a wide diversity of available holdin$s fro" the securities "aret. The annual return fro" an

0>


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invest"ent in 4 deends on the uncertain behaviour of the "utual fund under varyin$ econo"ic conditions.

The investors available actions (aiE = 1, -, 3, ) are as followsa1* o not invest

a-

* /elect invest"ent A the 6F ban savin$s lan.a3* /elect invest"ent >, the .+ F $overn"ent bond.a* /elect invest"ent 4, the uncertain "utual fund

Bbserve that actions a1 to a3 do not involve uncertainty as the outco"esassociated with the" do not deend on uncertain "aret conditions. Bbservealso that action a - do"inates actions a1 and a3. n addition, action a1 is clearlyinferior to the ris0free ositive $rowth invest"ent alternatives a - and a3 as itrovides for no $rowth of the rincial a"ount.

Action a is associated with an uncertain outco"e that, deendin$ on the state of the econo"y, "ay roduce either a ne$ative return or a ositive return. Thusthere e#ists no aarent do"inance relationshi between action a and action a-,the best a"on$ the actions involvin$ no uncertainty.

/uose the investor believes that if the "aret is down in the ne#t year, aninvest"ent in the "utual fund would lose 1' ercent returnsE if the "aret staysthe sa"e, the invest"ent would stay the sa"eE and if the "aret is u, theinvest"ent would $ain -' ercent returns. The investor has thus defined thestates of nature for his;her invest"ent decision0"ain$ roble" as follows*

s1* The "aret is down.s-* The "aret re"ains unchan$ed.s3* The "aret is u.

A study of the "aret co"bined with econo"ic e#ectations for the co"in$ year "ay lead the investor to attach sub?ective robabilities of '.-+, '.-+, and '.+',resectively, the the states of nature, s1, s-, and s3. The "a?or !uestion is then,how can the investor use the fore$oin$ infor"ation re$ardin$ invest"ents A, >,and 4, and the e#ected "aret behaviour serves as an aid in selectin$ theinvest"ent that best satisfies his;her ob?ectivesG This !uestion will beconsidered in the sections that follow.

3.2 Anal"sis of the !ecision %ro&lemn roble"s involvin$ choices fro" "any alternatives, one "ust identify all the

actions that "ay be taen and all the states of nature whose occurrence "ayinfluence decisions. The action to tae none of the listed alternatives whoseoutco"e is nown with certainty "ay also be included in the list of actions.

Associated with each action is a list of ayoffs. f an action does not involve ris,the ayoff will be the sa"e no "atter which state of nature occurs.

01


42/131

The ayoffs associated with each ossible outco"e in a decision roble" shouldbe listed in a payoff table, defined as a listin$, in tabular for", of the valueayoffs associated with all ossible actions under every state of nature in adecision roble".

The ayoff table is usually dislayed in $rid for", with the states of natureindicated in the colu"ns and the actions in the rows. f the actions are labeleda1, a-, @, an, and the states of nature labeled s1, s-, @, s, a ayoff table for adecision roble" aears as in table 3.-.1 below. ote that a ayoff is enteredin each of the n cells of the ayoff table, one for the ayoff associated with eachaction under every ossible state of nature.

Ta&le 3.2.1: The %a"off Ta&le'TAT( O) *AT$R(

ACT+O* s1 s- s3 @ s

a1a-a3...an

(xample

The "ana$in$ director of a lar$e "anufacturin$ co"any is considerin$ three

otential locations as sites at which to build a subsidiary lant. To decide whichlocation to select for the subsidiary lant, the "ana$in$ director will deter"inethe de$ree to which each location satisfies the co"anyHs ob?ectives of "ini"isin$ transortation costs, "ini"isin$ the effect of local ta#ation, andhavin$ access to an a"le ool of available se"i0silled worers. 4onstruct aayoff table and ayoff "easures that effectively ran each otential locationaccordin$ to the de$ree to which each satisfies the co"anyHs ob?ectives.

'olution9et the three otential locations be sites A, >, and 4. To deter"ine a ayoff "easure to associate with each of the co"anyHs ob?ectives under each

alternative, the "ana$in$ director sub?ectively assi$ns a ratin$ on a ' to 1'scale to "easure the de$ree to which each location satisfies the co"anyHsob?ectives. or each ob?ective, a ' ratin$ indicates co"lete dissatisfaction,while a 1' ratin$ indicates co"lete dissatisfaction. The results are resented intable 3.-.- below*

0-


43/131

Ta&le 3.2.2: Ratings for three alternative plant sites for aManufacturing Compan"

ALTERNATIVE COMPAN O!"ECTIVE

Transortation 4ostsTa#ation 4ostsorforce Pool

/ite A

667

/ite >

:6

/ite 4

1'+

To co"bine the co"onents of ayoff, the "ana$in$ director ass hi"self, whatare the relative "easures of i"ortance of the three co"any ob?ectives haveconsidered as co"onents of ayoffG /uose the "ana$in$ director decidesthat "ini"isin$ transortation costs is "ost i"ortant and twice as i"ortant aseither the "ini"i%ation of local ta#ation or the si%e of worforce available.De;she thus assi$ns a wei$ht of - to the transortation costs and wei$hts of 1each to ta#ation costs and worforce. This will $ive rise to the followin$ ayoff

"easures*Payoff (/ite A) = 6(-) 5 6(1) 5 7(1) = -+

Payoff (/ite >) = (-) 5 :(1) 5 6(1) = -3

Payoff (/ite 4) = 1'(-) 5 +(1) 5 (1) = -:

3.3 'elf,Assessment (xerciseEnumerate the maor areas of business decisionma!ing" ?ow does the study of managerial economics help a business manager in decisionma!ingD

-. Conclusion&his unit focuses on business decision analysis" &he idea is that the most plausible wayof ma!ing business decisions is to loo! at and analyse business opportunities$ variables$

and challenges" &o help you carry out these important tas!s$ the unit presents important

discussions on:1" and uncertainty in decision analysis

-" of decision problems

. 'ummar"This unit infor"s you that "ost decision0"ain$ situations involve the choice of one a"on$ several alternatives actions. The alternative actions and their corresondin$ ayoffs are usually nown to the decision0"aer in advance.hen the state if nature, si, whether nown or unnown, has no influence on theoutco"es of $iven alternatives, you will say that the decision "aer is oeratin$under certainty. Btherwise, he;she is oeratin$ under uncertainty. ecision"ain$ under certainty aears to be si"ler than that under uncertainty. Cnder certainty, the decision "aer si"ly araises the outco"e of each alternativeand selects the one that best "eets his;her ob?ective.

0/


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n roble"s involvin$ choices fro" "any alternatives, one "ust identify all theactions that "ay be taen and all the states of nature whose occurrence "ayinfluence decisions. The action to tae none of the listed alternatives whoseoutco"e is nown with certainty "ay also be included in the list of actions.

Associated with each action is a list of ayoffs. f an action does not involve ris,

the ayoff will be the sa"e no "atter which state of nature occurs./. Tutor,Mar0e# Assignmentor each of the followin$ business decision0"ain$ roble"s, list the actionsavailable to the decision "aer and the states of nature that "i$ht result to affectthe ayoff*

(a) The relace"ent of "anually oerated aca$in$ "achines by a fullyauto"ated "achineE

(b) The leasin$ of a co"uter by a co""ercial ban o rocess checs andhandle internal accountin$E

(c) The e#ansion of the "aret of a brewery fro" a two0state "aret to either afour0state "aret or a seven0state "aretE

(d) The assi$n"ent of seven secretaries to seven e#ecutivesE and,

(e) The invest"ent of a co"any ension fund.

. References4wivedi$ 4" : EPECTED MONETARY VALUE DECISIONS DECISION8

MAING INVOLVING SAMPLE INFORMATION AND

TIME PERSPECTIVE IN BUSINESS DECISIONS

Content

00


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1.' ntroduction-.' Bb?ectives3.' "ortant eatures of >usiness ecision0&ain$ Processes3.1 I#ected &onetary Jalue ecisions3.- ecision &ain$ nvolvin$ /a"le nfor"ation

3.3 Ti"e Persective in >usiness ecisions3. /elf0Assess"ent I#ercise.' 4onclusion+.' /u""ary6.' Tutor0&ared Assi$n"ent7.' References

1. +ntro#uction As you noted in unit 6, decision analysis rovides you with decision0"ain$fra"ewor based on available infor"ation on the business environ"ent, in thefor" of either sa"le infor"ation or ?ud$"ent infor"ation or both. n this unit,we e#a"ine the i"ortant features of business decision "ain$ as they relate toe#ected "onetary values, availability of sa"le infor"ation, and ti"eersective.

2. O&ectivesDavin$ $one throu$h this unit, you will be able to*

1. Dave additional levera$e in decision "ain$ rocesses-. >e infor"ed on how to "ae e#ected "onetary value decisions3. Cse sa"le infor"ation in rofitable business decisions. Cnderstand and tae into consideration ti"e ersectives in businesslannin$.

3. +mportant )eatures of usiness !ecision,Ma0ing %rocesses

3.1 (xpecte# Monetar" 4alue !ecisions A decision0"ain$ rocedure, which e"loys both the ayoff table and rior robabilities associated with the states of nature to arrive at a decision is referredto as the E#pected Monetary Value decision rocedure. ote that by prior

probability we "ean robabilities reresentin$ the chances of occurrence of theidentifiable states of nature in a decision roble" rior to $atherin$ any sa"leinfor"ation. The e#pected $onetary %alue decision refers to the selection of available action based on either the e#ected oortunity loss or the e#ected

rofit of the action.

ecision "aers are $enerally interested in the opti$al $onetary %aluedecisions. The oti"al e#ected "onetary value decision involves the selectionof the action associated with the "ini"u" e#pected opportunity loss or the actionassociated with the "a#i"u" e#pected profit, deendin$ on the ob?ective of thedecision "aer.

02


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The concet of e#ected "onetary value alies "athe"atical e#ectation,where oortunity loss or rofit is the rando" variable and the rior robabilitiesreresent the robability distribution associated with the rando" variable.

The expected opportunity loss is co"uted by*E&Li ' ( )all * Li* P&s * ', &i ( +, , -, n'

where 9i? is the oortunity loss for selectin$ action a i $iven that the state of nature, s ?, occurs and P&s * ' is the rior robability assi$ned to the state of nature,s ?.

The expected profits for each action is co"uted in a si"ilar way*

E& i ' ( )all * i* P&s * '

where Ki? reresents rofits for selectin$ action ai

(xample

>y recordin$ the daily de"and for a erishable co""odity over a eriod of ti"e,a retailer was able to construct the followin$ robability distribution for the dailyde"and levels*

Ta&le 3.1.1: %ro&a&ilit" !istri&ution for the !ail" !eman#

s ?1-3 or "ore

P&s * '

'.'

'.+'.3'.-

The oortunity loss table for this de"and0inventory situation is as follows*

Ta&le 3.1.2: The Opportunit" 5oss Ta&le/tate of ature, e"and

Action, nventory

a1(1)a-(-)a3(3)

s1(1)

'-

s-(-)

3'-

s3(3)

63'

e are re!uired to find the inventory level that "ini"ises the e#ectedoortunity loss.

03


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3.2

'olutionLiven the rior robabilities in the first table, the e#ected oortunity loss areco"uted as follows*

E&Li ' ( ) *(+/Li* P&s * ', for eac0 in%entory le%el, I ( +, , /.

The e#ected oortunity losses at each inventory level beco"e*

E&L+ ' ( '('.+) 5 3('.3) 5 6('.-) = -.1'

E&L ' ( -('.+) 5 '('.3) 5 3('.-) = 1.6'

E&L/ ' = ('.+) 5 -('.3) 5 '('.-) = -.6'

t follows that in order to "ini"i%e the e#ected oortunity loss, the retailer should stoc - units of the erishable co""odity. This is the oti"al decision.

!ecision Ma0ing +nvolving 'ample +nformationn discussin$ rior robabilities, recall it was noted that rior robabilities areac!uired either by sub?ective selection or by co"utation fro" historical data. ocurrent infor"ation describin$ the robability of occurrence of the states of naturewas assu"ed to be available.

n "any cases, observational infor"ation or other evidence are available to thedecision "aer either for urchase or at the cost of e#eri"entation. or e#a"le, a retailer whose business deends on the weather "ay consult a"eteorolo$ist before "ain$ decisions, or an investor "ay hire a "aretconsultant before investin$. &aret surveys carried out before the release of anew roduct reresent another area in which the decision "aer "ay seeadditional infor"ation. n each of these e#a"les, the decision "aer atte"tsto ac!uire infor"ation relative to the occurrence of the states of nature fro" asource other than that fro" which the rior robabilities were co"uted.

hen such infor"ation are available, !aye1s La2 can be e"loyed to revise therior robabilities to reflect the new infor"ation. These revised robabilities arereferred to as posterior probabilities.

>y definition, the posterior probability reresented sy"bolically by P&s3 4#' is the

robability of occurrence of the state of nature s, $iven the sa"le infor"ation,#. This robability is co"uted by*

P&s 3 4#' ( Ps3 'P&s3 ')all i Psi 'P&si '

0@


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The robabilities, Psi ' are the conditional robabilities of observin$ theobservational infor"ation, #, under the states of nature, si, and the robabilitiesP&si ' are the rior robabilities.

The e#ected "onetary value decisions are for"ulated in the sa"e way as

before, e#cet that the osterior robabilities are used instead of rior robabilities. f the ob?ective is to "ini"i%e the e#ected oortunity loss, the!uantity is co"uted for each action ai. The e#ected oortunity loss in thiscase is co"uted by*

E&Li ' ( )all I Li* P&si 4#' I ( +, , /,-,n

(xamplet is nown that an asse"bly "achine oerates at a + ercent or 1' ercentdefective rate. hen runnin$ at a 1' ercent defective rate, the "achine is saidto be out of control. t is then shut down and read?usted. ro" ast e#erience,the "achine is nown to run at + ercent defective rate :' ercent of the ti"e. Asa"le of si%e n = -' has been selected fro" the outut of the "achine, and y =- defectives have been observed. >ased on both the rior and sa"leinfor"ation, what is the robability that the asse"bly "achine is in control(runnin$ at + ercent defective rate)G

'olutionThe states of nature in this e#a"le relates to the asse"bly "achine defectiverates. Thus the states of nature include*s1 = '.'+, and s- = '.1' with the assu"ed rior robabilities of occurrence of '.:'and '.1'. e are re!uired to use these rior robabilities, in line with theobserved sa"le infor"ation, to find the osterior robability associated with thestate of nature, s1.

n this roble", the Me#eri"ental infor"ation, #N is the observation of y = -defectives fro" a sa"le of n = -' ite"s selected fro" the outut of theasse"bly "achine. e need to find the robability that the e#eri"entalinfor"ation, #, could arise under each state of nature, s i. This can be done byreferrin$ to the bino"ial robability distribution table found in the aendi#.

Cnder the state of nature s1 = '.'+, we obtain*

P-.56' ( P&n ( 5, y (45.56' ( 5.76 8 5.9/: ( 5.+;7 (fro" the bino"ialdistribution table)

Cnder the state of nature, s- = '.1', we obtain*

P-.+5' ( P&n ( 5, y ( 45.+5' = '.677 '.3:- = '.-8+ (fro" the bino"ialdistribution table).

e now e"loy the >ayeHs 9aw to find the osterior robability that the "achineis in control (s1) based on both the rior and e#eri"ental infor"ation. To "ae

0B


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the wor easy, we use the 4olu"nar aroach to the use of >ayeHs 9aw asillustrated below*

Ta&le 3.2.1: Columnar Approach to $se of a"e6s 5a7

(1)

/tate of

(-)

Prior,

(3)

I#eri"ental

()

Product,

(+)

Posterior,ature,si

P&si ' nfor"ation,Psi '

P&si 'Psi ' P&si 4#'

s1s-

'.'+'.1'

'.:''.1'

'.18:'.-8+

'.17'1'.'-8+

'.86'.1

1.'' '.1:86 1.''

9ooin$ at colu"n (), we observe the roduct of the entries in colu"ns (-) and(3). These values "easure the *oint probabilities. The su" of the entries incolu"n () is the ter" in the deno"inator of the for"ula for >ayeHs 9aw and"easures the $ar


50/131

where forecastin$, lannin$, and ro?ections are involved. ecision0"aers "ustdecide on an aroriate future eriod for ro?ectin$ the value of a $ivenbusiness variable. Btherwise, ro?ections "ay rove "eanin$less fro" businessanalysis oint of view and decisions based thereon "ay result in oor ay0offs.or instance, in a business decision re$ardin$ the establish"ent of an institute of

entrereneurshi, ro?ectin$ a short0run de"and and tain$ a short0run ti"eersective will not be wise.

3.- 'elf,Assessment (xerciseLive the ?ustification for usin$ an e#ected "onetary value ob?ective in decisionroble"s.

5.0 C!n$#+%!n

&o beef up your understanding of business decisionma!ing this unit hasexamined the important features of decision ma!ing in business$ including:1" monetary value decisions

-" involving sample information

/" perspective in business decisions

6.0 S#-

ecision "aers are $enerally interested in the opti$al $onetary %aluedecisions. The oti"al e#ected "onetary value decision involves the selectionof the action associated with the "ini"u" e#pected opportunity loss or the actionassociated with the "a#i"u" e#pected profit, deendin$ on the ob?ective of thedecision "aer. All business decisions are taen with so"e ti"e ersective. Ti"e ersectiverefers to the duration of ti"e eriod e#tendin$ fro" the relevant ast toforeseeable future, taen into consideration while "ain$ a business decision.The relevant ast refers to the eriod of ast e#erience and trends which arerelevant for business decisions with lon$0run i"lications.

=.0 T#t!8M-2" A++%4nnt

A business erson is tryin$ to decide whether to tae one of two contracts or neither one. De;she has si"lified the situation and feels it is sufficient toi"a$ine that the contracts rovide the alternatives shown in the followin$ table*

Contract A Contract %rofit1'','''

+',''''

03','''

%ro&a&ilit"'.-''.''.3''.1'

%rofit

','''1','''01','''

%ro&a&ilit"

'.3''.''.3'

2>


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(a) hich contract should the business erson select if he;she wishes to"a#i"i%e his;her e#ected rofitG(b) hat is the e#ected rofit associated with the oti"al decisionG

>.0 R,n$+

4wivedi$ 4" +bectives

/"> 5nalysis of Mar!et 4emand/"1 4efinition of Mar!et 4emand

21


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/"- &ypes of 4emand/"/ 4eterminants of Mar!et 4emand/"0 6elf5ssessment Exercise0"> 9onclusion

2"> 6ummary


1.0 Int!"#$t%!n

This unit discusses the "eanin$ of "aret de"and, tyes of de"and,deter"inants of "aret de"and, the de"and functions, elasticities of de"and,and techni!ues of de"and forecastin$. This is in reco$nition of the fact that theanalysis of "aret de"and for a business fir"Hs roduct lays an i"ortant rolein business decision "ain$. n addition, for a fir" to succeed in its oerations, it"ust lan for future roduction, the inventories of raw "aterials, advertise"ents,and sales outlets. t follows that the nowled$e of the "a$nitude of the currentand future de"and is indisensable.

The analysis of "aret de"and enables business e#ecutives now*6. the factors deter"inin$ the si%e of consu"er de"and for their roductsE7. the de$ree of resonsiveness of de"and to chan$es in its deter"inantsE8. the ossibility of sales ro"otion throu$h "aniulation of ricesE:. resonsiveness of de"and to advertise"ent e#endituresE and,1'. oti"u" levels of sales, inventories, and advertise"ent e#enditures.

2. O&ectives

At the end of this unit, you should be able to*1. 2now what the "aret de"and is all about-. Cnderstand the various tyes of de"and3. >e fa"iliar with the deter"inants of de"and

3.0 An-+%+ !, M-2t D-n"

3.1 D,%n%t%!n !, M-2t D-n"

&he mar!et demand of any product is the sum of individual demands for the product at agiven mar!et price in a given time period"


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T-' 3.1.1: T7 M-2t D-n" S$7"#

P%$ !, A 9#-nt%t !, A D-n"" ': M-2t D-n"

Y

1>

B

30

->

2

@

1>10

->-@

1

-

03

1>12

>

>

1-

0B

3

C

12--

/02>

3.& T/+ !, D-n"

&he maor types of demand encountered in business decisions are outlined below"

3.&.1. In"%*%"#- -n" M-2t D-n".

&he quantity of a commodity an individual is willing and able to purchase at a particular

price$ during a specific time period$ given hisPher money income$ hisPher taste$ and pricesof other commodities$ such as substitutes and complements$ is referred to as thein%i,i%&al %e!an% for the commodity" 5s illustrated in table /"1 above$ the total

quantity which all the consumers of the commodity are willing and able to purchase at agiven price per time unit$ given their money incomes$ their tastes$ and prices of other commodities$ is referred to as the !ar(et %e!an% for the commodity"

3.&.&. ,! ,%@+ -n" In"#+t@+ P!"#$t.

&he quantity of a firm*s product that can be sold at a given price over time is !nown as

the demand for the firm*s product" &he sum of demand for the products of all firms inthe industry is referred to as the mar!et demand or industry demand for the product"

3.2.3 A#t!n!!#+ -n" D%*" D-n".5n autonomous demand or direct demand for a commodity is one that arises on its ownout of a natural desire to consume or possess a commodity" &his type of demand is

independent of the demand for other commodities" 5utonomous demand may also arisedue to demonstration effect of a rise in income$ increase in population$ and advertisement

of new products"

&he demand for a commodity which arises from the demand for other commodities$called parent products’ is called derived demand. 4emand for land$ fertili'ers andagricultural tools$ is a derived demand because these commodities are demanded due to

demand for food" #n addition$ demand for bric!s$ cement$ and the li!e are derived

demand from the demand for house and other types of buildings" #n general$ demand for producer goods or industrial inputs is a derived demand"

3.2.- D-n" ,! D#-' -n" N!n8D#-' G!!"+.4urable goods are those goods for which the total utility or usefulness is not exhaustible

in the shortrun use" 6uch goods can be used repeatedly over a period of time" 4urableconsumer goods include houses$ clothing$ shoes$ furniture$ refrigerator$ and the li!e"

2/


54/131

4urable producer goods include mainly the items under fixed assets*$ such as building$ plant$ machinery$ and office furniture"

&he demand for durable goods changes over a relatively longer period than that of thenondurable goods" &he demand for nondurable goods depends largely on their current

prices$ consumers* income$ and fashion" #t is also subect to frequent changes"

4urable goods create replacement demand$ while nondurable goods do not" #n addition$the demand for nondurable goods change linearly$ while the demand the demand for durable goods change exponentially as the stoc! of durable goods changes"

3.&.6. -n" L!n48t D-n".

Short2ter! %e!an% refers to the demand for goods over a short period" &he type of goods involved in the shortterm demand are most fashion consumer $oods, $oodsused seasonally, inferior substitutes for suerior $oods durin$ scarcities. /hort0ter" de"and deends "ainly on the co""odity rice, rice of their substitutes,current disosable income of the consumers$ the consumers* ability to adust their consumption pattern$ and their susceptibility to advertisement of new products"

&he lon2ter! %e!an% refers to the demand which exists over a long period of time"9hanges in longterm demand occur only after a long period" Most generic goods havelongterm demand" &he longterm demand depends on the longterm income trends$

availability of better substitutes$ sales promotion$ consumer credit facility$ and the li!e"

3.3 Dt%n-nt+ !, M-2t D-n"

;or corporate managers at large and specifically$ the mar!eting managers$ it is highlyimportant to understand the factors affecting the mar!et demand for their products" &his

understanding is required for analysing and estimating demand for the products" &houghthere are several factors affecting mar!et demand for a product$ the most important are:1" Price of the pro%&ct or the o+n price 4Po50 &his is the most important determinant of

demand for a product" &he own price of a product and the quantity demanded of it are

inverselyrelated so that$To U >

T7o

-" Price of the relate% oo%s) s&ch as s&-stit&tes an% co!ple!ents 4Ps an% Pc5 Ahentwo goods are substitutes for each other$ the change in price of one affects the demand for the other in the same direction" #f goods Q and I are substitute goods$ then an increase in

the price of Q will give rise to an increase in the demand for I"


55/131

4x

Q

4y

I

6ymbolically$ 4x F f(7y), T4xPT7y U >

4y F f(7x), T4yPT7x U >

Ahen two goods are complements for each other$ one complements the use of another" 7etrol and car a complement goods" #f an increase in the price of onegood causes a decrease in demand for the other$ the goods are said to be

complements" &hus if the demand function for a car (4c) in relation to petrol

price (7p) is specified by:

4c f(7p)$ T4cPT7p O >"

/" Cons&!ers Inco!e &his is the maor determinant of demand for any product sincethe purchasing power of the consumer is determined by the disposable income"

Managers need to !now that incomedemand relationship is of a more varied nature thanthose between demand and its other determinants"

&he relationship between demand for commodity Q$ for example$ and the consumer*sincome$ say I$ !eeping other factors constant$ can be expressed by a demand function:

4x F f(I)$ and T4xPTI U >"

Iou should note that consumer goods of different nature have different relationships withincome of different categories of consumers" &he manager needs$ therefore$ to be

completely aware of the goods they deal with and their relationship with consumer*sincome$ particularly with respect to the assessment of both existing and prospective

demand for a product"

%egarding incomedemand analysis$ consumer goods and services are grouped under four broad categories:

i" Essential Cons&!er Goo%s 4ECG50 Goods and services in this category are referredto as basic needs*$ and are consumed by all persons in a society" 6uch goods andservices include food grains$ salt$ vegetable oil$ coo!ing$ fuel$ housing$ and minimumclothing" &he demand for such goods and services increase with increases in consumer*s

income$ but only up to a certain limit$ even though the total expenditure may increase in

accordance with the quality of goods consumed$ all things being equal" &he relationship between goods and services of this category and consumer*s income is shown by thecurve E9G in figure /"/"- below"

F%4# 3.3.&: In$!8D-n" R-t%!n+7%/+

9onsumer*s

22


56/131

#ncome (I) E9G Q1 Q-uantity 4emanded (Q)

ii" Inferior Goo%s 4IG50 #nferior and superior goods are widely !nown to both buyersand sellers" Economists define inferior goods as goods in which their demands decrease

as consumer*s income increases$ beyond a certain level of income" &he relationship between income and demand for an inferior good is illustrated by curve #G in figure

/"/"- above" 4emand for such goods rises only up to a certain level of income$ say

(+I1)$ and declines as income increases beyond this level"

iii" Nor!al Goo%s 4NG50 #n economic terms$ normal goods are goods demanded inincreasing quantities as consumer*s income rises" of normal goods are

clothing$ furniture$ and automobiles" &he type of relationship between income and

demand for normal goods is shown by curve


57/131

>

(b) by showing the product*s superiority over the rival product,(c) by influencing consumer*s choice against the rival product, and$(d) by setting new fashions and changing tastes" &he impact of these causes upwardshifts in the demand for the product" things being equal$ as expenditure on

advertisement increases$ it is expected that volume of sales will increase" &he

relationship between sales (6) and advertisement outlays (54) can be expressed by thefunction:

6 F f(54)$ and T6PT54 U >" relationship is indicated in figure /"/"/ below:

F%4# 3.3.3 A"*t%+nt -n" S-+

olume of 6ales (I) 6ales curve

5dvert" Expenditure (


58/131

inferiority$ and the desire to raise once social status" 7urchases based on these factors arethe result of what economists refer to as demonstration effect* or the andAagoneffect*" &hese effects have positive impacts on commodity demand"

+n the contrary$ when a commodity becomes a thing of common use$ some rich people

decrease their consumption of such goods" &his behaviour is referred to in economics asthe snob effect*" &his has negative impact on the demand for the commodity concerned"

+ther determinants of demand for commodities include Consu

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