MEFA notes for Nature and scope of managerial economics

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

INTRODUCTION:

Economics is a study of human activity both at individual and national level.

Earning money and spending this money to satisfy our wants such as food, clothing, shelter and others.

Such activities of earning and spending money are called ‘economic’ activity.

ADAM SMITH was the father of economics.

DEFINITIONS:

1. According to Adam Smith, “The study of nature of national wealth”.

2. Dr. Alfred Marshall,”Economics is a study of man’s actions in the ordinary business of life; it enquires how he get his income and how he uses it.”

3. A.C.Pigov, “the study of economic welfare that can be brought directly and indirectly, into relationship with the measuring rod of money”.

4. Prof. Lionel Robbins, “The science which studies human behavior as a relationship between ends and scarce means which have alternative uses”.

Salient features of economics according to Prof. Robbins,

1. unlimited wants
2. scarce resources
3. alternative uses
4. choice

Micro economics: the study of an individual consumer or firm is called micro economics. Also called ‘the theory of firm’.

Macro economics: the study of aggregate or total level of economic activity in a country is called macro economics.

Factors for production:-

- Land

- Labour

- Capital

- Organization

- Technology

Management:-

Management is the science and art of getting things done through people in formally organized groups.

Functions of management are planning, organizing, staffing, directing and controlling.

Manager: a manager gets things done through people in an organization.

Resources: men, material, machines, money and technology.

A manager is responsible for achieving the targeted results. The manager’s task is to

maximize the profits of the firm and minimizes the costs.

He has to take such decisions. Planning the production, fixing the selling price,

adding a particular product or dropping it from the product line.

NATURE OF MANAGERIAL ECONOMICS

1. close to micro economics
2. Normative statements (team of people to do the work).
3. Operates against the backdrop of macro economics.
4. Prescriptive actions (goal oriented).
5. Applied in nature (help to managers for decision making).
6. Offers scope to evaluate each alternative (better alternative to maximum the profits for the firm).
7. Interdisciplinary.
8. Assumptions and limitations.

SCOPE OF MANAGERIAL ECONOMICS:-

THE MAIN AREAS OF MANAGERIAL ECONOMICS:

1. Demand decisions.
2. Input-output.
3. Price-output.
4. Price-related.
5. Investment.
6. Economic forecasting and forward planning.

LINKAGES WITH OTHER DISCIPLINES:-

• Economics.
• Operations research.
• Mathematics.
• Statistics.
• Accountancy.
• Psychology.
• Organizational behavior.

DEMAND ANALYSIS

DEMAND DETERMINANTS, LAW OF DEMAND AND ITS EXCEPTIONS

INTRODUCTION: -

The scope of economics broadly comprises

1. Consumption: - it deals with the behaviour of consumers to plan his operations.
2. Production: - a producer has to understand the consumer’s behaviour pattern before he commits his funds for production. This is the reason why consumption proceeds production.
3. Exchange: - it deals with how the goods, once produced, are sold for a price to customers.
4. Distribution: - it deals with how the sale proceeds the goods sold are distributed among the various factors of production towards the rents, wages, interest & profits.

BASIC LAWS OF CONSUMPTION:-

1. Law of diminishing marginal utility.
2. The law of equi-marginal utility.
3. Consumer surplus.
4. The concepts of indifference curves.
5. Consumer equilibrium.

Law of diminishing marginal utility:

The law of diminishing marginal utility states that the marginal utility derived on the consumption of every additional unit goes on diminishing other things remaining the same.

Ex: - first sweet will give more utility.

Second sweet gives lesser utility.

Third sweet gives still lesser utility.

If additional units of the same sweets are consumed the amount of total utility goes on increasing but at diminishing rate. This implies that the marginal utility is reducing from one level to the other level of consumption.

The Law of equi-marginal utility:

It explains the pre requisite for the consumer is in equilibrium. It states that the consumer to be in equilibrium when the marginal utilities obtained from the products bought are equal, in other words, the consumer maximizes his total utility by allocating his income among the goods and services available to him in such a way that the marginal utility from one good equals the marginal utility from the other good.

In other words:

Marginal utility of product ‘X’  = marginal utility of product ‘Y’

Price of ‘X’ price of ‘Y’

Where X and Y refers to the products bought.

Ex:-marginal utility schedule of consumer C:

Unit bought pants shirts

1 40 35

2 32 28

3 28 20

4 20 10

5 10 8

Suppose each pant or shirt cots 100/- the consumer C has 500/- with him. He will not buy all the pants or only shirts, with the money available. A combination of 3 pants and 2 shirts will give him maximum satisfaction.

Total satisfaction of buying 3 pants is more than 3 shirts. It is because the marginal utility derived on the 3rd pant is equal to that obtained on the second shirt.

Inferences:-

1. The 1st buy would be a pant because it provides higher marginal utility. The customer prefers to buy a pant first.
2. The second unit will be shirt only, because the second unit of a pant gives 32 units of marginal utility where as the shirt gives 35 units.
3. In case the customer has an extra 100/- he would buy either pant or shirt because both yield equal marginal utility.

Consumer surplus:-

It is defined as the difference between the price that the consumer is prepared to pay the price that he is exactly paying. In other words, it is the value consumers get from a good without paying for it.

Ex:- salt or sugar: if the price of salt or sugar goes up to 10/- per kg. The consumer would be prepared to pay for it. If the salt is available for 5/- per kg, then the consumer surplus is 5/- per kg.

The indifference curve:-

A consumer is said to be in equilibrium, when he maximizes his utility, given the budget constraint. When the budget line is tangential to any of the indifference curves, then he is said to be in equilibrium.

An indifference curve is which reveals certain combinations of goods or services which yields him the same utility. The consumer is indifferent to a particular combination as every combination is yielding him the same utility.

From the above figure it is clear that any combination of AD,BE,CF of goods X and Y yield the consumer 200 units of satisfaction. When the consumer is indifferent for a particular combination it is called indifference curve. In case he wants higher satisfaction, he has to operate on the next level of indifference curve which yields him 300 units.

Assumptions for indifference curve:-

1. the consumer behaves rationally(to maximize his satisfaction)
2. the prices and incomes of the consumer are defined for analysis(tastes and preferences of the consumer do not change during the analysis)

Properties of indifference curve:-

1. It slopes downwards from left to right:- if the consumption of product A is increased, the consumption of product B has to be reduced, this leads to a downward slope in the curve.
2. It is convex to the origin:- here the consumer is substituting one product for the other. So the rate at which the substitution takes place determines the degree of convexity. This is called marginal rate of substitution, which impulses the quantity of product A given up to obtain certain quantity of product B.
3. It can’t intersect with another indifference curve because each is defined at a particular level of satisfaction. In case the consumer wants higher or lesser satisfaction he chooses that particular indifference curve to operate two indifferences can neither touch, nor have a common point and they cant intersect.

Consumer equilibrium:-

A consumer is said to be equilibrium when he maximizes his utility, given the budget constraint, when the budget line is tangential to any of the indifference curves, then he is said to be in equilibrium.

Indifference curve showing consumer equilibrium.

From the above figure, it can be seen that the budget line is tangential to the indifference curve which yields the consumer a satisfaction of 200 units.

Limitations of utility theory:-

All the theories are based on the utility concept, there is one limitation of the utility concept. It can be ranked only, it can’t be measured absolutely. In the earlier analysis, absolute values were given because we assumed that it could be measured absolutely, it is necessary that the managerial economist should identify different faces of consumer behaviour. The indifference curve approach reveals more on the consumer behaviour.

DEMAND ANALYSIS:

Demand:

Every want supported by the willingness and ability to buy constitutes demand for a particular product or service. In other words, if we want a car and I cant pay for it, there is no demand for the car for my side.

A product or service is said to have demand when three conditions are satisfied.

1. Desire on the part of the buyer to buy.
2. Willingness to pay for it.
3. Ability to pay the specified price for it.

Unless all these conditions are fulfilled, the product is not said to have any demand.

NATURE AND TYPES OF DEMAND:-

Demand always implies at a given price how much is the quantity demanded at a given level of price? This is the volume of demand. The use and characteristics of

Different products affect their demand. In other words a product with more number of uses is naturally more in demand than one with a single use.

1. Consumer goods vs. Producer goods.
2. Autonomous demand vs. Derived demand.
3. Durable vs. Perishable goods.
4. Firm demand vs. Industry demand.
5. Short-run demand vs. Long-run demand.
6. New demand vs. Replacement demand.
7. Total market and Segment market demand.

1. CONSUMER GOODS VS. PRODUCER GOODS:

Consumer goods means the products and services which capable of satisfactory human needs. Goods can be grouped into consumer goods and producer goods.

Consumer goods are those which are available for ultimate consumption, these give direct and immediate satisfaction.

Ex: - bread, apple, rice.

Producer goods are those which are used foe further processing or production of goods or services to cash income.

Ex: - machinery, tractor.

These goods yield satisfaction indirectly, these are used to produce consumer goods and sometimes these goods can be producer goods as well as consumer goods.

Ex: - Paddy.

A farmer having 10 bags of paddy may use 5 bags for his personal consumption and the other 5 bags as seeds for next crop. So here paddy is both producer good and a consumer good. The demand for producer good in “indirect” and demand for consumer goods in “direct”.

2. AUTONOMOUS DEMAND VS DERIVED DEMAND:-

Autonomous demand refers to the demand foe products & services directly.

Ex: - The demand for the services of a super specialty hospital can be considered as autonomous, where as the demand for hotels around that hospital is called a derived demand, if there is no demand for houses, there may not be demand for steel, cement, bricks, demand for houses is autonomous whereas demand for these inputs is derived demand.

3. DURABLE VS. PERISHABLE GOODS: -

Here the demand for goods is classified based on their durability. Durable goods are those goods which give service relatively for a long period. The life of perishable goods is very less, may be in hours or days.

Ex: - milk, vegetables, fish.

Rice, wheat, sugar, these are examples for durable goods.

Freezing facilities, the life of perishable goods can be extended for sometime.

Products such as:

TV, refrigerator, and washing machines are useful for a longer period, hence they are classified as consumer durables.

4. FIRM DEMAND VS INDUSTRY DEMAND: -

The firm is a single business unit where as industry refers to group of firms carrying on similar activities. The quantity of goods demanded by a single firm is called firm demand and the quantity demanded by the industry as a whole is called industry demand.

Ex: - one construction company may use 100 tonnes of cement during a given month. This is a firm demand. The construction industry in a particular state may have used ten million tonnes. This is industry demand.

5. SHORT-RUN DEMAND VS LONG-RUN DEMAND: -

Joel dean defines short-run demand as, “the demand with its immediate reaction to price changes, income fluctuations”.

Long-run demand is that demand, which will ultimately exist as a result of the changes in pricing, promotion or product improvement,

• The demand for a particular product or service in a given region for a particular day can be viewed as short-run demand.
• The demand for a longer period for the same region can be viewed as long-run demand. The demand that can be created in the long-run by changes in the design as a result of changes in technology is long-run demand.
• Short-run refers to a period of shorter duration & long-run refers to the relatively period of longer duration.

In short-run additional changes can’t be made, but in long-run it can be made like living of additional plant, we can’t expand the output overnight. The short-run is a period in which the firms can adjust their production by changing variable factors such as material & labour. They can’t change fixed factors such as technology or capital. The long-run is a period relatively long so that all factors of production including capital can be adjusted to meet the market requirements.

6. NEW DEMAND VS REPLACEMENT DEMAND: -

New demand refers to the demand for the new products and it is addition to the existing stock. In replacement demand, the item is purchased to maintain the asset in good condition.

Ex: - the demand for cars is new demand and demand for spare parts is

Replacement demand.

7. TOTAL MARKET AND SEGMENT MARKET DEMAND: -

Ex: - sugar

The consumption of sugar in a given region, the total demand for sugar in the region is the total market demand.

The demand for sugar from the sweet, making industry from this region is the segment market demand.

FACTORS DETERMINING DEMAND: -

The demand for a particular product depends on several factors, the following factors determine the demand for a given product.

1. Price of the product (P).
2. Income level of the consumer (I).
3. Tastes and preferences of the consumer (T).
4. Prices of related goods which may be substitutes or complimentary (Pr).
5. Expectations about the prices in future (Ep).
6. Expectations about the income in future (EI).
7. Size of population (Sp).
8. Distribution of consumers over different regions (Dc).
9. Advertising efforts (A).
10. Any other factor capable of affecting the demand (O).

DEMAND FUNCTION: -

Demand function is a function which describes a relationship between one variable and its determinants it describes how much quantity of goods is bought at alternative prices of goods and related goods, alternative income levels and alternative values of other variables affecting demand. Thus the demand function for a good relates the quantity of a good which consumers demand during a given period to the factors which influence the demand.

If we see mathematically, the demand function for a product A can be expressed like.

Qd = f (P, I, T, PR, Ep, Ei, Sp, Di, A, O)

Some impacts:-

1. Price of the product.
2. Income of the consumer
3. Prices of substitutes or complimentaries.
4. Tastes and preferences.

LAW OF DEMAND;-

The Law of Demand states: other things remaining the same, the amount of

quantity demanded rises with every fall of in the price and vice versa.

The Law of demand states the relationship between price and demand of a particular product or service it makes an assumption that all other demand determinants remain the same or do not change.

ASSUMPTIONS OF THE LAW OF DEMAND:-

The phrase other things remaining the same is the assumption under the law of demand. Here other things include income level of the consumer, tastes and preferences of the consumer, price of related goods, expectations about the prices or incomes in the future, size of population, advertising, efforts and any other factor capable of affecting the demand.

OPERATIONS OF THE LAW OF DEMAND:-

The law of demand explains that with every fall in price of a particular product, its demand goes on increasing and vice versa. This holds good as long as other determinants of demand do not change. Once there is change in the other demand determinants the law does not hold good.

From the figure in the normal course, at OP price, the quantity demanded is OQ. If the price falls from P to P1 then the higher quantity OQ1 is bought. DD is the demand curve.

This shows that there is n inverse relationship between the demand and the price. it can be seen that the demand curve is sloping downwards from left to right. There are certain exceptions to this law. In other words, the law does not hold good in the following cases.

1. Where there is a shortage of necessities feared:- if the customers fear that there could be shortage of necessities. Then this law does not hold good. They may tend to buy more than what they require immediately, even if the price of the product increases.
2. Where the product is such that it confers distinction:- products such as jewels diamonds and so on, confer distinction on the part of the user. In such a case, the consumers tends to buy (to maintain their prestige) even though there is increase in its price, such products are called ‘veblen’ goods.
3. Giffen’s paradox: people whose incomes are low purchase more of a commodity such as broken rice, bread, etc.(which is their staple food). when its price rises conversely when its price falls, instead of buying more, they buy les of this commodity and use the savings for the purchase of better goods such as meat. This phenomenon is called Giffen’s paradox & such goods are called Inferior giffen goods.
4. In case of ignorance of price changes:- at times the customer may not keep track of changes in price in such a case, he tends to buy even if there is increase in price.

In case of these exceptions, the demand curve slopes upwards. This exceptional curve is shown below

Exceptional demand curve

CHANGE IN DEMAND: -

The increase or decrease in demand due to change in the factors other than prices to change in the factors other than price is called change in demand. Change in demand leads to a shift in the demand curve to the right or the left.

INCREASE IN DEMAND:-

If the consumers are willing and able to buy more of rainbow shirts at the same price, the result will be an increase in demand. The demand curve will shift to the right.

From the above figure, how the demand increases from D, D to D1, D1, it shows that the buyers are ready to buy more quantity of arrow shirts at the same price.

DECREASE IN DEMAND:-

A decrease in demand occurs when buyers are ready to buy less of a product at the same price because of factors like fall in income, rise in price of complementary

goods and so on. A decrease in demand will shift the demand curve to the left.

From the above figure the demand curve D, D decreases to D1, D1 at the same price level OP, the quantity demanded also decreases from OQ to OQ1. Increase or decrease in demand involves a shift in the demand curve.

Extension and contraction in demand:-

An extension is the downward movement along a demand curve, which indicates that a higher quantity is demanded for a given fall in the price of the good. A contraction is the upward movement along a demand curve, which indicates that a lower quantity is demand for a given increase in the price of the good.

From above figure it can be seen that at OP, the quantity demanded is OQ. When the price decreases from OP to OP1, the quantity demanded extends from OQ to OQ1 along the same curve. There is no shift, here in the demand curve, This is called extension in demand.

Contraction refers to movement upwards along the same demand curve, when the price increases from OP to OP2, the demand contracts from OQ to OQ2 along the same demand curve, this is called contraction in demand.

In the case of extension and contraction, the change is along the same demand curve, either downwards or upwards respectively.

Significance of law of demand:-

The law of demand is the primary law in the consumption theory in economics, it indicates the consumer behaviour for a given change in the variables in the study, despite the assumption that other things remaining the same, the results of the law of demand are time tested and have been the basis for further decisions relating to costs, outputs, investments, appraisals and so on. This provides the basis for analysis of other economic laws.