Unit-1

Meaning of Economics-
The branch of knowledge concerned with the production, consumption, and transfer of
wealth. Economics is a social science concerned with the factors that determine
the production, distribution, and consumption of goods and services. 'Political economy' was the
earlier name for the subject, but economists in the late 19th century suggested "economics" as a
shorter term for "economic science" to establish itself as a separate discipline outside of political
science and other social sciences
Economics is the study of the production and consumption of goods and the transfer of
wealth to produce and obtain those goods. Economics explains how people interact within markets
to get what they want or accomplish certain goals. Since economics is a driving force of human
interaction, studying it often reveals why people and governments behave in particular ways.
The term economics is derived from the word “oeconomicus” by Xenophon in 431 B.C. It is
derived from two words economy and science. Economy means proper utilization of resources. It
means economics is the science of economy or science of proper utilization of resources. It is
comprised of theories, laws, principle related to utilization of resources so as to solve the economic
problems, satisfy the human wants or need and so on
A study of economics can describe all aspects of a country’s economy, such as how a country
uses its resources, how much time laborers devote to work and leisure, the outcome of investing in
industries or financial products, the effect of taxes on a population, and why businesses succeed or
fail.
Adam Smith, known as the Father of Economics, established the first modern economic
theory, called the Classical School, in 1776. Smith believed that people who acted in their own self-
interest produced goods and wealth that benefited all of society. He believed that governments
should not restrict or interfere in markets because they could regulate themselves and, thereby,
produce wealth at maximum efficiency. Classical theory forms the basis of capitalism and is still
prominent today.
A second theory known as Marxism states that capitalism will eventually fail because factory
owners and CEOs exploit labor to generate wealth for themselves. Karl Marx, the theory’s
namesake, believed that such exploitation leads to social unrest and class conflict. To ensure social
and economic stability, he theorized, laborers should own and control the means of production.
While Marxism has been widely rejected in capitalistic societies, its description of capitalism’s flaws
remains relevant.
A more recent economic theory, the Keynesian School, describes how governments can act
within capitalistic economies to promote economic stability. It calls for reduced taxes and increased
government spending when the economy becomes stagnant and increased taxes and reduced
spending when the economy becomes overly active. This theory strongly influences U.S. economic
policy today. As one can see, economics shapes the world. Through economics, people and
countries become wealthy. Because buying and selling are activities vital to survival and success,
studying economics can help one understand human thought and behavior.

Nature and Scope of Economics

During the 19th century, the social sciences emerged and separate disciplines were carved out.
Economics, psychology, sociology, politics, anthropology and other branches of social science
developed as separate fields of study. In the last part of the 19th century, “political economy”
became “economics.” Since that time, economics has been frequently defined as “the study of how
scarce resources are allocated to satisfy unlimited wants.” As a professional discipline, economics is
often regarded as a decision science that seeks optimal solutions to technical allocation problems.
In this text, economics is presented from two perspectives. One perspective is the technical
analysis of the processes by which scarce resources are allocated for competing ends. An
alternative perspective is the social context of provisioning.
Economics as A Study Of The Allocation Of Scarce Resources
Economics as A Study Of Provisioning
. However, the economics is defined in different ways by different economists.
There are mainly three definitions of economics:-

 classical or wealth definition (Adam Smith)-1776 A.D

 neo-classical or welfare definition (Alfred Marshall )-1890 A.D
 modern or scarcity and choice definition (Lionel Robbins)-1932 A.D

Classical or wealth definition (Adam Smith)-1776 A.D

The famous classical economist Adam smith for the firs time defined economics as “science
of wealth”. The definition was given in the book “an enquiry to the nature and the causes of wealth
of nations” published in 1776 A.D. the book is popularly known as “wealth of nations”. According
to smith, labor is the main source of income or wealth. More wealth is accumulated only if more
labor is used. Economics explains the human behavior and activities they do for wealth. This
definition was based upon the assumptions of full employment, perfect competition, no
governmental interventions, money just as a medium of exchange and so on.
This definition has following main proposition:-
 economics is science of wealth
 Labor is the only source of income
 there is perfect competition in product as well as labor market
 the government should not interfere the activities of people and business organizations
 This definition is influenced by physiocracy and mercantilism.
Criticism
Wealth definition has over emphasized wealth. Economics is science of human activities
rather than only wealth. Adam smith considers only material things or wealth as subject matter of
economics but human beings require some immaterial things like self esteem or dignity, social
prestige, national identity and so on too. The immaterial things are called essential things for
human satisfaction. Wealth definition is based upon the theory of subsistence wage which is known
as iron law of wage. The law was against the workers and in favor of employers. Adam smith
doesn’t explain about scarcity of resource and choice of best alternative for the use of resources.
The problem of scarcity and choice is burning issue in the modern economics but he fails to explain
about the problems of scarcity and choice. The wealth definition is based upon assumptions of full
employment and perfect competition but none of these two is in existence. This definition is based
upon the assumption of no intervention of government in economic activities of people and
business organization but we find in every country more or less governmental intervention.

Neo-classical or welfare definition (Alfred Marshall)-1890 A.D

In 1890, Alfred Marshall, a famous neo-classical economist and a great
contributor to micro economics defined economics as the science of material welfare. Here, the
material welfare means the quantities of physical goods consumed by people. If the people are
consuming large quantities of goods, they are said to have high level of welfare into two types
 material welfare
 immaterial welfare
According to him, only the material welfare is the subject matter of economics. He assumes every
person is rational and s/he uses the resources in his/her possession very properly so as to maximize
their own welfare. Economics is therefore the science that studies the rational behavior revealed
by the people. Major propositions of Marshall’s welfare definition are:-
 Economics is science of material welfare
 Economics is social science i.e. science of mankind
 Economics is the study of rational behavior of people revealed for maximization of material
welfare.
Criticisms:-
This definition of economics a science of material welfare was assumed correct until the arrival of
Lionel Robbins. He criticized the definition under the following aspects:-
 Classificatory activities of Marshall into material non material welfare, economics and non
economic goods is only classificatory not analytical because single human cannot be material
as well as non material according to the nature and purpose of work.
 Non material activities like feeling of social service, human desire also satisfy human needs.
This idea has not been prioritized
  Non welfare consumption like harmful drugs, tobacco, and alcohol don’t promote social
welfare but still are in the study of economics
 Economics should study about total human beings but wealth definition doesn’t study about
isolated people like saints, nuns, monks etc.
 Modern or scarcity and choice definition (Lionel Robbins)-1932 A.D

Modern Theory
According to Lionel Robbins, economics is the science of scarcity of the resources and the choice of
best alternative for their utilization. The resources are limited in supply. Each resource is usable for
different purposes. The wants or need of people are unlimited. The wants differ in importance.
They differ from place to place, from time to time and from person to person. Some wants are
more important whereas some are not. All wants cannot be fulfilled because of insufficiency of
resources. Therefore, we have to go on utilizing the resources in such a way, so that, our more
wants can be fulfilled leaving no one in most important wants unfulfilled. For it, we must select
best ways for the utilization of the resources. We should have the complete information of
resources available, needs of the country and their importance and ways for the utilization of
resources. This definition is given in 1930 A.D after WWI. During third decade of the twentieth
century, the European countries were badly in need of large quantities of resources for
rehabilitation, construction of infrastructures, renovation etc. they were destructed in war. This
definition is both normative and positive in nature.

The major propositions are:-

 there is unlimited human needs or wants
 there is scarce means of resources
 there are alternative use of resources
 there is need of choice

Criticisms:
The definition is criticized in the following ways:-
 economic problems arises not only due to scarcity but due to under, miss or over utilization
of resources
 economic problems arises due to inequality too
 there is political consideration
 needs and resources may vary

Superiority of Robbins definition over Marshall’s definition:-

 the definition is scientific
  the definition is universally accepted
 the definition has wide scope
 the definition has science of choice

Meaning of Science, Engineering and Technology

Science- The word science comes from the Latin "scientia," meaning knowledge.
How do we define science? According to Webster's New Collegiate Dictionary, the definition of
science is "knowledge attained through study or practice," or "knowledge covering general truths
of the operation of general laws, esp. as obtained and tested through scientific method [and]
concerned with the physical world."
What does that really mean? Science refers to a system of acquiring knowledge. This system uses
observation and experimentation to describe and explain natural phenomena.
The term science also refers to the organized body of knowledge people have gained using that
system. Less formally, the word science often describes any systematic field of study or the
knowledge gained from it.

 a branch of knowledge or study dealing with a body of facts or truths

systematically arranged and showing the operation of general laws
 Systematic knowledge of the physical or material world gained through
observation and experimentation.
 Any of the branches of natural or physical science
 Systematized knowledge in general.
 Knowledge, as of facts or principles; knowledge gained by systematic study.
 A particular branch of knowledge.
 Skill, especially reflecting a precise application of facts or principles, proficiency.

Engineering - the branch of science and technology concerned with the design, building, and use of
engines, machines, and structures

 The art or science of making practical application of the knowledge of pure sciences, as
physics or chemistry, as in the construction of engines, bridges, buildings, mines, ships, and
chemical plants.
 The action, work, or profession of an engineer.
 Digital Technology. the art or process of designing and programming computer
systems: computer engineering;
 Skillful or artful contrivance; maneuvering.
 Basically, to put it into simple terms, engineering is where you solve problems. To add a bit
more to it, engineers use technical, as well as scientific knowledge in order to make judgments. By
using their imaginations, they come up with solutions to problems either new or old. It is by using
the application of technical and scientific knowledge that engineers put judgment, imagination and
reasoning to work in order to come up with new solutions to human problems or new ways to solve
old problems. So, if that has left you feeling a bit hazy, the best way to summarize all of this is that
engineers are problem solvers.

Technology
 The branch of knowledge that deals with the creation and use of technical means and their
interrelation with life, society, and the environment, drawing upon such subjects as
industrial arts, engineering, applied science, and pure science.
 The application of this knowledge for practical ends.
 The terminology of an art, science, etc.; technical nomenclature.
 A scientific or industrial process, invention, method, or the like.
 The sum of the ways in which social groups provide themselves with the material objects of
their civilization.

Managerial Economics − Definition

A close interrelationship between management and economics had led to the development
of managerial economics. Economic analysis is required for various concepts such as demand,
profit, cost, and competition. In this way, managerial economics is considered as economics
applied to “problems of choice’’ or alternatives and allocation of scarce resources by the firms.
Managerial economics is a discipline that combines economic theory with managerial
practice. It helps in covering the gap between the problems of logic and the problems of policy.
The subject offers powerful tools and techniques for managerial policy making.
To quote Mansfield, “Managerial economics is concerned with the application of economic
concepts and economic analysis to the problems of formulating rational managerial decisions.
Spencer and Siegelman have defined the subject as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”

Nature and Scope of Managerial Economics

The most important function in managerial economics is decision-making. It involves the
complete course of selecting the most suitable action from two or more alternatives. The primary
function is to make the most profitable use of resources which are limited such as labor, capital,
land etc. A manager is very careful while taking decisions as the future is uncertain; he ensures
that the best possible plans are made in the most effective manner to achieve the desired
objective which is profit maximization.

 Economic theory and economic analysis are used to solve the problems of managerial
economics.
 Economics basically comprises of two main divisions namely Micro economics and
Macro economics.

 Managerial economics covers both macroeconomics as well as microeconomics, as both are

equally important for decision making and business analysis.
 Macroeconomics deals with the study of entire economy. It considers all the factors such as
government policies, business cycles, national income, etc.
 Microeconomics includes the analysis of small individual units of economy such as individual
firms, individual industry, or a single individual consumer.

All the economic theories, tools, and concepts are covered under the scope of managerial
economics to analyze the business environment. The scope of managerial economics is a continual
process, as it is a developing science. Demand analysis and forecasting, profit management, and
capital management are also considered under the scope of managerial economics.
Demand Analysis and Forecasting
Demand analysis and forecasting involves huge amount of decision-making! Demand estimation is
an integral part of decision making, an assessment of future sales helps in strengthening the
market position and maximizing profit. In managerial economics, demand analysis and forecasting
holds a very important place.
Profit Management
Success of a firm depends on its primary measure and that is profit. Firms are operated to earn
long term profit which is generally the reward for risk taking. Appropriate planning and measuring
profit is the most important and challenging area of managerial economics.
Capital Management
Capital management involves planning and controlling of expenses. There are many problems
related to capital investments which involve considerable amount of time and labor. Cost of
capital and rate of return are important factors of capital management.
Demand for Managerial Economics
The demand for this subject has increased post liberalization and globalization period primarily
because of increasing use of economic logic, concepts, tools and theories in the decision making
process of large multinationals.

Unit- 2
Demand Meaning-
Economists use the term demand to refer to the amount of some good or service
consumers are willing and able to purchase at each price. Demand is based on needs and wants—a
consumer may be able to differentiate between a need and a want, but from an economist’s
perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay, you
have no effective demand.
What a buyer pays for a unit of the specific good or service is called price. The total number of
units purchased at that price is called the quantity demanded. A rise in price of a good or service
almost always decreases the quantity demanded of that good or service. Conversely, a fall in price
will increase the quantity demanded. When the price of a gallon of gasoline goes up, for example,
people look for ways to reduce their consumption by combining several errands, commuting by
carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this
inverse relationship between price and quantity demanded the law of demand. The law of demand
assumes that all other variables that affect demand are held constant.

'Law of Demand'
The 'Law Of Demand' states that, all other factors being equal, as the price of a good or service
increases, consumer demand for the good or service will decrease, and vice versa. There is an
inverse relationship between quantity demanded and its price. The people know that when price
of a commodity goes up its demand comes down. When there is decrease in price the demand for
a commodity goes up. There is inverse relation between price and demand. The law refers to the
direction in which quantity demanded changes due to change in price.

Assumptions of the law

1. There is no change in income of consumers.

2. There is no change in the price of product.
3. There is no change in quality of product.
4. There is no substitute of the commodity.
5. The prices of related commodities remain the same.
6. There is no change in customs.
7. There is no change in taste and preference of consumers.
8. The size of population remains the same.
9. The climate and weather conditions are same.
10. The tax rates and other fiscal measures remain the same.

The determinants of demand:

i. Price of a Product or Service: Affects the demand of a product to a large extent. There is an
inverse relationship between the price of a product and quantity demanded. The demand for a
product decreases with increase in its price, while other factors are constant, and vice versa. For
example, consumers prefer to purchase a product in a large quantity when the price of the product
is less. The price-demand relationship marks a significant contribution in oligopolistic market where
the success of an organization depends on the result of price war between the organization and its
competitors.

ii. Income: Constitutes one of the important determinants of demand. The income of a consumer
affects his/her purchasing power, which, in turn, influences the demand for a product. Increase in
the income of a consumer would automatically increase the demand for products by him/her,
while other factors are at constant, and vice versa. For example, if the salary of Mr. X increases,
then he may increase the pocket money of his children and buy luxury items for his family. This
would increase the demand of different products from a single family. The income-demand
relationship can be analyzed by grouping goods into four categories, namely, essential consumer
goods, inferior goods, normal goods, and luxury goods. The relationship between the income of a
consumer and each of these goods is explained as follows:
a. Essential or Basic Consumer Goods:
Refer to goods that are consumed by all the people in the society. For example, food grains, soaps,
oil, cooking fuel, and clothes. The quantity demanded for basic consumer goods increases with
increase in the income of a consumer, but up to a fixed limit, while other factors are constant.
b. Normal Goods:
Refer to goods whose demand increases with increase in the consumer’s income. For example,
goods, such as clothing, vehicles, and food items, are demanded in relatively increasing quantity
with increase in consumer’s income. The demand for normal goods varies due to .different rate of
increase in consumers’ income.
c. Inferior Goods:
Refer to goods whose demand decreases with increase in the income of consumers. For example, a
consumer would prefer to purchase wheat and rice instead of millet and cooking gas instead of
kerosene, with increase in his/her income. In such a case, millet and kerosene are inferior goods for
the consumer.
However, these two goods can be normal goods for people having lower level of income.
Therefore, we can say that goods are not always inferior or normal; it is the level of income of
consumers and their perception about the need of goods.
d. Luxury Goods:
Refer to goods whose demand increases with increase in consumer’s income. Luxury goods are
used for the pleasure and esteem of consumers. For example, expensive jewellery items, luxury
cars, antique paintings and wines, and air travelling.
iii. Tastes and Preferences of Consumers: Play a major role in influencing the individual and market
demand of a product. The tastes and preferences of consumers are affected due to various factors,
such as lifestyles, customs, common habits, and change in fashion, standard of living, religious
values, age, and sex. A change in any of these factors leads to change in the tastes and preferences
of consumers. Consequently, consumers reduce the consumption of old products and add new
products for their consumption. For example, if there is change in fashion, consumers would prefer
new and advanced products over old- fashioned products, provided differences in prices are
proportionate to their income. Apart from this, demand is also influenced by the habits of
consumers. For instance, most of the South Indians are non-vegetarian; therefore, the demand for
non- vegetarian products is higher in Southern India. In addition, sex ratio has a relative impact on
the demand for many products. For instance, if females are large in number as compared to males
in a particular area, then the demand for feminine products, such as make-up kits and cosmetics,
would be high in that area.

iv. Price of Related Goods: Refer to the fact that the demand for a specific product is influenced by
the price of related goods to a greater extent. Related goods can be of two types, namely,
substitutes and complementary goods, which are explained as follows:
a. Substitutes:
Refer to goods that satisfy the same need of consumers but at a different price. For example, tea
and coffee, jowar and bajra, and groundnut oil and sunflower oil are substitute to each other. The
increase in the price of a good results in increase in the demand of its substitute with low price.
Therefore, consumers usually prefer to purchase a substitute, if the price of a particular good gets
increased.
b. Complementary Goods:
Refer to goods that are consumed simultaneously or in combination. In other words,
complementary goods are consumed together. For example, pen and ink, car and petrol, and tea
and sugar are used together. Therefore, the demand for complementary goods changes
simultaneously. The complementary goods are inversely related to each other. For example,
increase in the prices of petrol would decrease the demand of cars.

v. Expectations of Consumers: Imply that expectations of consumers about future changes in the
price of a product affect the demand for that product in the short run. For example, if consumers
expect that the prices of petrol would rise in the next week, then the demand of petrol would
increase in the present. On the other hand, consumers would delay the purchase of products
whose prices are expected to be decreased in future, especially in case of non-essential products.
Apart from this, if consumers anticipate an increase in their income, this would result in increase in
demand for certain products. Moreover, the scarcity of specific products in future would also lead
to increase in their demand in present.
vi. Effect of Advertisements: Refers to one of the important factors of determining the demand for
a product. Effective advertisements are helpful in many ways, such as catching the attention of
consumers, informing them about the availability of a product, demonstrating the features of the
product to potential consumers, and persuading them to purchase the product. Consumers are
highly sensitive about advertisements as sometimes they get attached to advertisements endorsed
by their favorite celebrities. This results in the increase demand for a product.

vii. Distribution of Income in the Society: Influences the demand for a product in the market to a
large extent. If income is equally distributed among people in the society, the demand for products
would be higher than in case of unequal distribution of income. However, the distribution of
income in the society varies widely. This leads to the high or low consumption of a product by
different segments of the society. For example, the high income segment of the society would
prefer luxury goods, while the low income segment would prefer necessary goods. In such a
scenario, demand for luxury goods would increase in the high income segment, whereas demand
for necessity goods would increase in the low income segment.

viii. Growth of Population: Acts as a crucial factor that affect the market demand of a product. If
the number of consumers increases in the market, the consumption capacity of consumers would
also increase. Therefore, high growth of population would result in the increase in the demand for
different products.

ix. Government Policy: Refers to one of the major factors that affect the demand for a product. For
example, if a product has high tax rate, this would increase the price of the product. This would
result in the decrease in demand for a product. Similarly, the credit policies of a country also induce
the demand for a product. For example, if sufficient amount of credit is available to consumers, this
would increase the demand for products.

x. Climatic Conditions: Affect the demand of a product to a greater extent. For example, the
demand of ice-creams and cold drinks increases in summer, while tea and coffee are preferred in
winter. Some products have a stronger demand in hilly areas than in plains. Therefore, individuals
demand different products in different climatic conditions.

Demand elasticity is a measure of how much the quantity demanded will change if another factor
changes. Demand elasticity refers to how sensitive the demand for a good is to changes in other
economic variables, such as the prices and consumer income. Demand elasticity is calculated by
taking the percent change in quantity of a good demanded and dividing it by a percent change in
another economic variable. A higher demand elasticity for a particular economic variable means
that consumers are more responsive to changes in this variable, such as price or income.
Law of demand explains the inverse relationship between price and demand of a commodity but it
does not explain to the extent to which demand of a commodity changes due to change in price. A
measure of a variable's sensitivity to a change in another variable is elasticity. In economics,
elasticity refers the degree to which individuals change their demand in response to price or
income changes.
It is calculated as −
Elasticity = % Change in quantity / % Change in price

Changes in Demand

Change in demand is a term used in economics to describe that there has been a change, or shift
in, a market's total demand. This is represented graphically in a price vs. quantity plane, and is a
result of more/less entrants into the market, and the changing of consumer preferences. The shift
can either be parallel or nonparallel.
Extension of Demand- Other things remaining constant, when more quantity is demanded at a
lower price, it is called extension of demand.

Px Dx

15 100 Original

8 150 Extension

Contraction of Demand- Other things remaining constant, when less quantity is demanded at a
higher price, it is called contraction of demand.

Px Dx

10 100 Original

12 50 Contraction

Importance of Elasticity of Demand

● Importance to producer − A producer has to consider elasticity of demand before fixing the
price of a commodity.
 ● Importance to government − If elasticity of demand of a product is low then government
will impose heavy taxes on the production of that commodity and vice – versa.
● Importance in foreign market − If elasticity of demand of a produce is low in the
international market then exporter can charge higher price and earn more profit.

Price Elasticity of demand

The price elasticity of demand is the percentage change in the quantity demanded of a good or a
service, given a percentage change in its price. Time is also a significant factor affecting the price
elasticity of demand. Generally consumers take time to adjust to the changed circumstances. The
longer it takes them to adjust to a change in the price of a commodity, the lesser price elastic
would be to the demand for a good or service.
Income Elasticity
Income elasticity is a measure of the relationship between a change in the quantity demanded for
a commodity and a change in real income. Formula for calculating income elasticity is as follows −
Ei = % Change in quantity demanded / % Change in income

Following are the Features of Income Elasticity −

● If the proportion of income spent on goods remains the same as income increases, then
income elasticity for the goods is equal to one.
● If the proportion of income spent on goods increases as income increases, then income
elasticity for the goods is greater than one.
● If the proportion of income spent on goods decreases as income increases, then income
elasticity for the goods is less by one.

Cross Elasticity of Demand

An economic concept that measures the responsiveness in the quantity demanded of one
commodity when a change in price takes place in another good. The measure is calculated by
taking the percentage change in the quantity demanded of one good, divided by the percentage
change in price of the substitute good −
Ec = ΔqxΔpy × pyqy
● If two goods are perfect substitutes for each other, cross elasticity is infinite.
● If two goods are totally unrelated, cross elasticity between them is zero.
● If two goods are substitutes like tea and coffee, the cross elasticity is positive.
● When two goods are complementary like tea and sugar to each other, the cross elasticity
between them is negative.

The elasticity of demand is of great importance in managerial decision making.

1. In the Determination of Output Level:
For making production profitable, it is essential that the quantity of goods and services should be
produced corresponding to the demand for that product.
Since the changes in demand are due to the change in price, the knowledge of elasticity of demand
is necessary for determining the output level.
2. In the Determination of Price:
The elasticity of demand for a product is the basis of its price determination. The ratio in which the
demand for a product will fall with the rise in its price and vice versa can be known with the
knowledge of elasticity of demand. If the demand for a product is inelastic, the producer can charge
high price for it, whereas for an elastic demand product he will charge low price. Thus, the
knowledge of elasticity of demand is essential for management in order to earn maximum profit.
3. In Price Discrimination by Monopolist:
Under monopoly discrimination the problem of pricing the same commodity in two different
markets also depends on the elasticity of demand in each market. In the market with elastic
demand for his commodity, the discriminating monopolist fixes a low price and in the market with
less elastic demand, he charges a high price.
4. In Price Determination of Factors of Production:
The concept of elasticity for demand is of great importance for determining prices of various
factors of production. Factors of production are paid according to their elasticity of demand. In
other words, if the demand of a factor is inelastic, its price will be high and if it is elastic, its price
will be low.
5. In Demand Forecasting:
The elasticity of demand is the basis of demand forecasting. The knowledge of income elasticity is
essential for demand forecasting of producible goods in future. Long-term production planning and
management depend more on the income elasticity because management can know the effect of
changing income levels on the demand for his product.
6. In Dumping:
A firm enters foreign markets for dumping his product on the basis of elasticity of demand to face
foreign competition.
7. In the Determination of Prices of Joint Products:
The concept of the elasticity of demand is of much use in the pricing of joint products, like wool and
mutton, wheat and straw, cotton and cotton seeds, etc. In such cases, separate cost of production
of each product is not known. Therefore, the price of each is fixed on the basis of its elasticity of
demand. That is why products like wool, wheat and cotton having an inelastic demand are priced
very high as compared to their by-products like mutton, straw and cotton seeds which have an
elastic demand.
8. In the Determination of Government Policies:
The knowledge of elasticity of demand is also helpful for the government in determining its
policies. Before imposing statutory price control on a product, the government must consider the
elasticity of demand for that product. The government decision to declare public utilities those
industries whose products have inelastic demand and are in danger of being controlled by
monopolist interests depends upon the elasticity of demand for their products.
9. Helpful in Adopting the Policy of Protection:
The government considers the elasticity of demand of the products of those industries which apply
for the grant of a subsidy or protection. Subsidy or protection is given to only those industries
whose products have an elastic demand. As a consequence, they are unable to face foreign
competition unless their prices are lowered through sub-sidy or by raising the prices of imported
goods by imposing heavy duties on them.
10. In the Determination of Gains from International Trade:
The gains from international trade depend, among others, on the elasticity of demand. A country
will gain from international trade if it exports goods with less elasticity of demand and import those
goods for which its demand is elastic.
In the first case, it will be in a position to charge a high price for its products and in the latter case it
will be paying less for the goods obtained from the other country. Thus, it gains both ways and shall
be able to increase the volume of its exports and imports.
Unit- 3
Demand Forecasting
All organizations operate in an atmosphere of uncertainty but decisions must be made today that
affect the future of the organization. There are various ways of making forecasts that rely on logical
methods of manipulating the data that have been generated by historical events. A forecast is a
prediction or estimation of a future situation, under given conditions. Demand forecast will help
the manager to take the following decisions effectively.

Short Run Decisions:

 Purchase of input
 Maintaining of economic level of inventory
 Setting up sales targets
 Distribution network
 Management of working capital
 Price policy
 Promotion policy

Long Run Decisions:

 Expansion of existing capacity
 Diversification of the product mix
 Growth of acquisition
 Change of location of plant
  Capital issues
 Long run borrowings
 Manpower planning

The steps to be followed:

 Identification of objectives
 Nature of product and market
 Determinants of demand
 Analysis of factors
 Choice of technology
 Testing the accuracy

Criteria to choose a method of forecasting are:

 Accuracy
 Plausibility
 Durability
 Flexibility
 Availability

The following are needed for demand forecasting (Why):

 Appropriate production scheduling
 Suitable purchase policy
 Appropriate price policy
 Setting realistic sales targets for salesmen
 Forecasting financial requirements
 Business planning
 Financial planning
 Planning man-power requirements

To select the appropriate forecasting technique, the manager/forecaster must be able to

accomplish the following:
1. Define the nature of the forecasting problem
2. Explain the nature of the data under investigation
3. Describe the capabilities and limitations of potentially useful forecasting techniques.
4. Develop some predetermined criteria on which the selection decision can be made.
Demand Forecasting Methods:
1. Survey of buyers’ intension
2. Delphi method
3. Expert opinion
4. Collective opinion
5. Naive model
6. Smoothing techniques
7. Time series / trend projection
8. Controlled experiments
9. Judgmental approach

Apart from the above mentioned statistical methods the survey methods are also commonly used.
They are:
1. Complete Enumeration Method: the survey covers all the potential consumers in the market
and an interview is conducted to find out the probable demand. The sum of all gives the total
demand for the industry. If the number of customers is too many this method cannot be used.
2. Sample Survey Method: the complete enumeration is not possible always. The forecaster can go
in for sample survey method. In this method, only few (a sample) customers are selected from the
total and interviewed and then the average demand is estimated.
3. Expert’s Opinion: the experienced people from the same field or from marketing agents can also
be taken into consideration for collecting information about the future demand.
The above discussed qualitative and quantitative methods are commonly used to forecast the
future demand and based on this information firms will take production decision.

Production Function
Production function indicates the maximum amount of commodity ‘X’ to be produced from various
combinations of input factors. It decides on the maximum output to be produced from a given level
of input, and how much minimum input can be used to get the desired level of output. The
production function assumes that the state of technology is fixed. If there is a change in technology
then there would be change in production function.

Q = f (Land, Labour, Capital, Organization)

Q = f (L, L, C, O)

The production manager’s responsibility is that of identifying the right combination of inputs for
the decided quantity of output. As a manager, he has to know the price of the input factors and the
budget allocation of the organization. The major objective of any business organization is
maximizing the output with minimum cost. To achieve the maximum output the firm has to utilize
the input factors efficiently. In the long run, without increasing the fixed factors it is not possible to
achieve the goal. Therefore it is necessary to understand the relationship between the input and
output in any production process in the short and long run.
Cobb Douglas Production Function:
This is a function that defines the maximum amount of output that can be produced with a given
level of inputs. Let us assume that all input factors of production can be grouped into two
categories such as labour (L) and capital (K).The general equilibrium for the production function is

Q = f (K, L)
There are various functional forms available to describe production. In general Cobb-Douglas
production function (Quadratic equation) is widely used

Q = A Kα Lβ
Q = the maximum rate of output for a given rate of capital (K) and labour (L).

Short Run Production Function:

In the short run, some inputs (land, capital) are fixed in quantity. The output depends on how much
of other variable inputs are used. For example if we change the variable input namely (labour) the
production function shows how much output changes when more labour is used. In the short run
producers are faced with the problem that some input factors are fixed. The firms can make the
workers work for longer hours and also can buy more raw materials. In that case, labour and raw
material are considered as variable input factors. But the number of machines and the size of the
building are fixed. Therefore it has its own constraints in producing more goods.

In the long run all input factors are variable. The producer can appoint more workers, purchase
more machines and use more raw materials. Initially output per worker will increase up to an
extent. This is known as the Law of Diminishing Returns or the Law of Variable Proportion.
To understand the law of diminishing returns it is essential to know the basic concepts of
production.
Measures of Productivity
Total production (TP): the maximum level of output that can be produced with a given amount of
input.
Average Production (AP): output produced per unit of input AP = Q/L
Marginal Production (MP): the change in total output produced by the last unit of an input
Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity produced to a given change
in the labour)
Marginal production of capital = Δ Q / Δ K (i.e. change in the quantity produced to a given change
in the capital)
The graphical representations of the production function are as shown in the following graph.

The Law Of Diminishing Returns

In the combination of input factors when one particular factor is increased continuously without
changing other factors the output will increase in a diminishing manner. Let us assume that a
person preparing for an examination continuously prepares without any break. The output or the
understanding and the coverage of the syllabus will be more in the beginning rather than in the
later stages. There is a limit to the extent to which one factor of production can be substituted for
another. The total production increases up to an extent and it gets saturated or there won’t be any
change in the output due to the addition of the input factor and further it leads to negative impact
on the output. That means the marginal production declines up to an extent and it reaches zero
and becomes negative. The point at which the MP becomes zero is the maximum output of the firm
with the given set of input factors. This law is applicable in all human activities and business
activities.
For example with two sewing machines and two tailors, a firm can produce a maximum of 14 pairs
of curtains per day. The machines are used only from 9 AM to 5 PM and the machines lie idle from
5 pm onwards. Therefore the firm appoints 2 more tailors for the second shift and the production
goes up to 28 units. Then adding two more labour to assist these people will increase the output to
30 units. When the firm appoints two more people, then there won’t be any change in their
production because their Marginal productivity is zero. There is no addition in the total production.
That means there is no use of appointing two more tailors. Therefore, there is a limit for output
from a fixed input factors but in the long run purchase of one more sewing machine alone will help
the firm to increase the production more than 30 units.

The Law of Returns To Scale

In the long run the fixed inputs like machinery, building and other factors will change along with the
variable factors like labour, raw material etc. With the equal percentage of increase in input factors
various combinations of returns occur in an organization.

Returns to scale: the change in percentage output resulting from a percentage change in all the
factors of production. They are increasing, constant and diminishing returns to scale.
Increasing returns to scale may arise: if the output of a firm increases more than in proportionate
to an increase in all inputs. For example the input factors are increased by 50% but the output has
doubled (100%).
Constant returns to scale: when all inputs are increased by a certain percentage the output
increases by the same percentage. For example input factors are increased by 50% then the output
has also increased by 50 percentages. Let us assume that a laptop consists of 50 components we
call it as a set. In case the firm purchases 100 sets they can assemble 100 laptops but it is not
possible to produce more than 100 units.
Diminishing returns to scale: when output increases in a smaller proportion than the increase in
inputs it is known as diminishing return to scale. For example 50% increment in input factors lead
to only 20% increment in the output.
From the graph given below we can see the total production (TP) curve and the marginal
production curve (MP) and average production curve (AP). It is classified into three stages; let us
understand the stages in terms of returns to scale.

Stage I: The total production increased at an increasing rate. We refer to this as increasing stage
where the total product, marginal product and average production are increasing.
Stage II: The total production continues to increase but at a diminishing rate until it reaches the
next stage. Marginal product, average product are declining but are positive. The total production
is at the maximum level at the end of the second stage with a zero marginal product.
Stage III: In this third stage total production declines and marginal product becomes negative. And
the average production also started decline. Which implies that the change in input factors there is
a decline in the overall production along with the average and marginal.
In economics, the production function with one variable input is illustrated with the well-known
law of variable proportions. (Below graph) it shows the input-output relationship or production
function with one factor variable while other factors of production are kept constant. To
understand a production function with two variable inputs, it is necessary know the concept iso-
quant or iso-product curve.

ISO-Quants
To understand the production function with two variable inputs, iso-quant curve is used. These
curves show the various combinations of two variable inputs resulting in the same level of output.
The shape of an Iso-quant reflects the ease with which a producer can substitute among inputs
while maintaining the same level of output. From the graph we can understand that the iso-quant
curve indicates various combinations of capital and labour usage to produce 100 units of motor
pumps. The points a, b or any point in the curve indicates the same quantum of production. If the
production increases to 200 or 300 units definitely the input usage will also increase therefore the
new iso-quant curve for 200 units (Q1) is shifted upwards. Various iso-quant curves presented in a
graph is called as iso- quant map.
Iso-cost: different combination of inputs that can be purchased at a given expenditure level.

The above graph explains clearly that the iso quant curve for 100 units of motor consists of ‘n’
number of input combinations to produce the same quantity. For example at ‘a’ to produce 100
units of motors the firm uses OC amount of capital and OL amount of labour i.e., more capital and
less labour force. At ’b’ OC1 amount of capital and OL1 labour force is used to produce the same
that means more labour and less capital.

Optimal input combination: The points of tangency between iso quant and iso cost curves depict
optimal input combination at different activity levels.

Expansion path: Optimal input combinations as the scale of production expand. From the graph it
is clear that the optimum combination is selected based on the tangency point of iso cost (budget
line) and iso- quant ie., a, b respectively. The point ‘a’ indicates that to produce 100 units of motor
the best combination of capital and labour are OC and OM which is within the budget. Over a
period of time a firm will face various optimum levels if we connect all points we derive expansion
path of a firm.
Unit- 4

Perfect competition- A perfectly competitive market is a hypothetical market where competition is

at its greatest possible level. Classical economists argued that perfect competition would produce
the best possible outcomes for consumers, and society.

Key characteristics
Perfectly competitive markets exhibit the following characteristics:

1. There is perfect knowledge, with no information failure or time lags in the flow of
information. Knowledge is freely available to all participants, which means that risk-taking is
minimal and the role of the entrepreneur is limited.
2. Given that producers and consumers have perfect knowledge, it is assumed that they make
decisions to maximize their self-interest - consumers look to maximize their utility, and
producers look to maximize their profits.
3. There are no barriers to entry into or exit out of the market.
4. Firms produce homogeneous, identical, units of output that are not branded.
5. Each unit of input, such as units of labor, are also homogeneous.
6. No single firm can influence the market price, or market conditions. The single firm is said to
be a price taker, taking its price from the whole industry. The single firm will not increase its
price independently given that it will not sell any goods at all. Neither will the rational
producer lower price below the market price given that it can sell all it produces at the
market price.
7. There are very many firms in the market - too many to measure. This is a result of having no
barriers to entry.
8. There is no need for government regulation, except to make markets more competitive.
9. There are assumed to be no externalities that is no external costs or benefits to third parties
not involved in the transaction.
10. Firms can only make normal profits in the long run, although they can make abnormal
(super-normal) profits in the short run.

The benefits
It can be argued that perfect competition will yield the following benefits:

1. Because there is perfect knowledge, there is no information failure and knowledge is shared
evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
 4. There is no need to spend money on advertising, because there is perfect knowledge and
firms can sell all they can produce. In addition, selling unbranded goods makes it hard to
construct an effective advertising campaign.
5. There is maximum possible:
 Consumer surplus
 Economic welfare
1. There is maximum allocative and productive efficiency:
 Equilibrium will occur where P = MC, hence allocative efficiency.
 In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.
1. There is also maximum choice for consumers.

How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For example, how
homogeneous is the output of real firms, given that even the smallest of firms working in
manufacturing or services try to differentiate their product.

The assumption that producers and consumers act rationally is questioned by behavioral
economists, who have become increasingly influential over the last decade. Numerous
experiments have demonstrated that decision making often falls well short of what could be
described as perfectly rational. Decision making can be biased and subject to rule of thumb
‘guidance’ when consumers and producers are faced with complex situations.

What is 'Monopolistic Competition'

Characterizes an industry in which many firms offer products or services that are similar, but not
perfect substitutes. Barriers to entry and exit in the industry are low, and the decisions of any one
firm do not directly affect those of its competitors. All firms have the same, relatively low degree of
market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is
sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in
the long run. Firms in monopolistic competition tend to advertise heavily.

Monopolistic competition is a type of imperfect competition such that many producers sell
products that are differentiated from one another (e.g. by branding or quality) and hence are not
perfect substitutes.

Characteristics

Monopolistically competitive markets exhibit the following characteristics:

1. Each firm makes independent decisions about price and output, based on its product, its
market, and its costs of production.
2. Knowledge is widely spread between participants, but it is unlikely to be perfect. For
example, diners can review all the menus available from restaurants in a town, before they
make their choice. Once inside the restaurant, they can view the menu again, before
ordering. However, they cannot fully appreciate the restaurant or the meal until after they
have dined.
3. The entrepreneur has a more significant role than in firms that are perfectly competitive
because of the increased risks associated with decision making.
4. There is freedom to enter or leave the market, as there are no major barriers to entry or
exit.
5. A central feature of monopolistic competition is that products are differentiated. There are
four main types of differentiation:
a. Physical product differentiation, where firms use size, design, color, shape,
performance, and features to make their products different. For example, consumer
electronics can easily be physically differentiated.
1. Marketing differentiation, where firms try to differentiate their product by distinctive
packaging and other promotional techniques. For example, breakfast cereals can
easily be differentiated through packaging.
2. Human capital differentiation, where the firm creates differences through the skill of
its employees, the level of training received, distinctive uniforms, and so on.
3. Differentiation through distribution, including distribution via mail order or through
internet shopping, such as Amazon.com, which differentiates itself from traditional
bookstores by selling online.
2. Firms are price makers and are faced with a downward sloping demand curve. Because each
firm makes a unique product, it can charge a higher or lower price than its rivals. The firm
can set its own price and does not have to ‘take' it from the industry as a whole, though the
industry price may be a guideline, or becomes a constraint. This also means that the demand
curve will slope downwards.
3. Firms operating under monopolistic competition usually have to engage in advertising. Firms
are often in fierce competition with other (local) firms offering a similar product or service,
and may need to advertise on a local basis, to let customers know their differences.
Common methods of advertising for these firms are through local press and radio, local
cinema, posters, leaflets and special promotions.
4. Monopolistically competitive firms are assumed to be profit maximizers because firms tend
to be small with entrepreneurs actively involved in managing the business.
5. There are usually a large numbers of independent firms competing in the market.
Examples of monopolistic competition
Examples of monopolistic competition can be found in every high street.

Monopolistically competitive firms are most common in industries where differentiation is possible,
such as:

 The restaurant business

 Hotels and pubs
 General specialist retailing
 Consumer services, such as hairdressing

Oligopoly

An oligopoly (from Ancient Greek (olígos), meaning "few", and (polein), meaning "to sell") is a
market form in which a market or industry is dominated by a small number of sellers (oligopolists).
Oligopolies can result from various forms of collusion which reduce competition and lead to higher
prices for consumers. Oligopoly has its own market structure.

With few sellers, each oligopolistic is likely to be aware of the actions of the others. According to
game theory, the decisions of one firm therefore influence and are influenced by decisions of other
firms. Strategic planning by oligopolists needs to take into account the likely responses of the other
market participants.

Characteristics

Profit maximization conditions- An oligopoly maximizes profits.

Ability to set price- Oligopolies are price setters rather than price takers.

Entry and exit- Barriers to entry are high. The most important barriers are government licenses,
economies of scale, patents, access to expensive and complex technology, and strategic actions by
incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to
entry often result from government regulation favoring existing firms making it difficult for new
firms to enter the market.

Number of firms- "Few" – a "handful" of sellers. There are so few firms that the actions of one firm
can influence the actions of the other firms.

Long run profits- Oligopolies can retain long run abnormal profits. High barriers of entry prevent
sideline firms from entering market to capture excess profits.

Product differentiation- Product may be homogeneous (steel) or differentiated (automobiles).

Perfect knowledge- Assumptions about perfect knowledge vary but the knowledge of various
economic factors can be generally described as selective. Oligopolies have perfect knowledge of
their own cost and demand functions but their inter-firm information may be incomplete. Buyers
have only imperfect knowledge as to price, cost and product quality.

Interdependence- The distinctive feature of an oligopoly is interdependence. Oligopolies are

typically composed of a few large firms. Each firm is so large that its actions affect market
conditions. Therefore, the competing firms will be aware of a firm's market actions and will
respond appropriately. This means that in contemplating a market action, a firm must take into
consideration the possible reactions of all competing firms and the firm's countermoves.

Non-Price Competition- Oligopolies tend to compete on terms other than price. Loyalty schemes,
advertising, and product differentiation are all examples of non-price competition.

Monopoly

A monopoly exists when a specific person or enterprise is the only supplier of a particular
commodity (this contrasts with a monophony which relates to a single entity's control of a market
to purchase a good or service, and with oligopoly which consists of a few entities dominating an
industry) Monopolies are thus characterized by a lack of economic competition to produce the
good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well
above the firm’s marginal that leads to a high monopoly profit. The verb monopolize or monopolize
refers to the process by which a company gains the ability to raise prices or exclude competitors. In
economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant
market power, that is, the power to charge overly high prices. Although monopolies may be big
businesses, size is not a characteristic of a monopoly. A small business may still have the power to
raise prices in a small industry (or market).

Characteristics

Profit Maximize: Maximizes profits.

Price Maker: Decides the price of the good or product to be sold, but does so by determining the
quantity in order to demand the price desired by the firm.

High Barriers: Other sellers are unable to enter the market of the monopoly.

Single seller: In a monopoly, there is one seller of the good that produces all the output. Therefore,
the whole market is being served by a single company, and for practical purposes, the company is
the same as the industry.
Price Discrimination: A monopolist can change the price and quality of the product. He or she sells
higher quantities, charging a lower price for the product, in a very elastic market and sells lower
quantities, charging a higher price, in a less elastic market.

Sources of monopoly power

Monopolies derive their market power from barriers to entry – circumstances that prevent or
greatly impede a potential competitor's ability to compete in a market. There are three major types
of barriers to entry: economic, legal and deliberate.

Economic barriers: Economic barriers include economies of scale, capital requirements, cost
advantages and technological superiority.

Economies of scale: Monopolies are characterized by decreasing costs for a relatively large range
of production. Decreasing costs coupled with large initial costs give monopolies an advantage over
would-be competitors. Monopolies are often in a position to reduce prices below a new entrant's
operating costs and thereby prevent them from continuing to compete. Furthermore, the size of
the industry relative to the minimum efficient scale may limit the number of companies that can
effectively compete within the industry. If for example the industry is large enough to support one
company of minimum efficient scale then other companies entering the industry will operate at a
size that is less than MES, meaning that these companies cannot produce at an average cost that is
competitive with the dominant company. Finally, if long-term average cost is constantly
decreasing, the least cost method to provide a good or service is by a single company.

Capital requirements: Production processes that require large investments of capital, or large
research and development costs or substantial sunk costs limit the number of companies in an
industry. Large fixed costs also make it difficult for a small company to enter an industry and
expand.

Technological superiority: A monopoly may be better able to acquire, integrate and use the best
possible technology in producing its goods while entrants do not have the size or finances to use
the best available technology. One large company can sometimes produce goods cheaper than
several small companies.

No substitute goods: A monopoly sells a good for which there is no close substitute. The absence
of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract
positive profits.

Control of natural resources: A prime source of monopoly power is the control of resources that
are critical to the production of a final good.
Network externalities: The use of a product by a person can affect the value of that product to
other people. This is the network effect. There is a direct relationship between the proportion of
people using a product and the demand for that product. In other words, the more people who are
using a product the greater the probability of any individual starting to use the product. This effect
accounts for fads, fashion trends, social networks etc. It also can play a crucial role in the
development or acquisition of market power. The most famous current example is the market
dominance of the Microsoft office suite and operating system in personal computers.

Legal barriers: Legal rights can provide opportunity to monopolize the market of a good.
Intellectual property rights, including patents and copyrights, give a monopolist exclusive control of
the production and selling of certain goods. Property rights may give a company exclusive control
of the materials necessary to produce a good.

Deliberate actions: A company wanting to monopolize a market may engage in various types of
deliberate action to exclude competitors or eliminate competition. Such actions include collusion,
lobbying governmental authorities, and force