UNIT – I: BUSINESS ECONOMICS AND DEMAND ANALYSIS

Definition - Nature and Scope of Business Economics - Demand:

Determinants of demand – Demand function - Law of demand, assumptions
and exceptions - Elasticity of demand – Types of elasticity of demand -
Demand forecasting and methods of demand forecasting.

INTRODUCTION OF ECONOMICS
Economics is a study of human activity both at individual and national level.
The economists of early age treated economics merely as the science of wealth. The
reason for this is clear. Every one of us in involved in efforts aimed at 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
activities”. It was only during the eighteenth century that Adam Smith, the Father of
Economics, defined economics as the study of nature and uses of national wealth’.
MEANING OF BUSINESS ECONOMICS
Business Economics is nothing but the application of economics theories and
principles management. It deals with decision-making at the level of a business firm.
Business managers use economic modes of thought to analyse business situation and
to make decisions. The Primary function of a business executive is decision making
and forward planning. Business Economics is also now as “Managerial Economics”.
DEFINITION OF BUSINESS ECONOMICS
“Use of economic analysis is formulating policies is known as problems”-Joel Dean
“Managerial Economics is economics applied in decision making”.-Hanyes, Mote
According to M.C.Nair and Meriam-“Business Economics consists of the use of
economic models of thought to analyse business problems”.
NATURE OF BUSINESS ECONOMICS

Micro in Nature

Pragmatic in Approach

NATURE OF BUSINESS
ECONOMICS Normative Science

A Scientific Art

Study of Macro
Environment
1. Micro in Nature
It is micro in Nature. This is because business economics is the study mainly at
the level of business firm. The appropriate title for micro economics is Price Theory.
One of the uses of price theory is the application of its method of analysis to business
problems. Its knowledge enables businessmen to take improved decision in demand
analysis, cost analysis and in fixation of prices. Linear programming, a new analytical
tool in price theory, is applied to business problems.
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2. Pragmatic in Approach
It is Pragmatic in its approach; it does not involve itself in theoretical
controversies. It is the application of economics analysis to decision making.
3. Normative Science
It is normative study. It prescribes standards or norms for policy making. It is
prescriptive rather than descriptive in nature. Economic theory builds laws of
economics such as law of demand. In business economics, the laws are applied for
policy determination at the level of the firm. Business Ethics is a guide to business
managers.
4. A Science Art
Business firms employ scientific methods of observation, reasoning and
Verification in analysing business problems. Demand forecasting is a scientific
analysis. Business economics may also be called an art because it helps management
in the efficient utilisation of scarce resources. It considers production costs, demand,
5. Study of Macro Environment
Business firms operate under macroeconomic environment. The macroeconomic
environment relating to national income, business cycles, economic policies of the
government in relation to business are important to managers. Business firms operate
on the basis of economic forecasts of national income, price levels, inflation rates etc.
SCOPE OF BUSINESS ECONOMICS
The scope of business economics covers all those economic theories which can
be used to find out solutions to business problems. It deals with demand analysis,
production analysis, cost analysis, pricing policies, profit management and capital
budgeting.

Demand
Analysis Production
Analysis
Product Policy,
Sales
Promotion &
Market Strategy SCOPE OF
BUSINESS Cost
ECONOMICS Analysis

Capital
Management
Pricing Decisions,
Profit Policies &
Practices
Management

1. Demand Analysis and Forecasting

Business decision-making depends on accurate estimates of demand. Demand
analysis in short, is necessary for two reasons for forecasting of demand and for
manipulation of demand. Demand analysis and forecasting occupies an important
place in business economics.
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2. Production Analysis
The resources made use of for production are scarce and these scarce
resources can be put to alternate uses. The factors of production i.e., the inputs, play
a vital role in the economics of production. A skilful management of inputs is
necessary to produce maximum output.
3. Cost Analysis
Firms attempt at minimisation of production costs. Cost estimates are essential
for decision-making. Managers know the causes for variations in costs. There is an
element of uncertainty because all causes are not known in advance. Cost control is
essential for pricing practices and profit planning.
4. Pricing Decisions, Policies and Practices
Price is the basis for revenue of a firm. Some of the aspects of the pricing
problem are price determination in various market forms, Pricing methods, differential
pricing, productive pricing and price forecasting.
5. Profit Management
Almost all the firms are working with the intension of making profit. The
success of firm is measured in terms of its profit. Profit is always uncertain. As the
future cost and revenue are uncertain future profit planning and measurement also
are very difficult.
6. Capital Management
Capital investments are the most complex problems. Capital management
implies planning and control of the capital expenditure, cost of capital etc. it is called
as Capital Budgeting or Long term Planning or Capital Expenditure Decision.
7. Product Policy, Sales Promotion and Market Strategy
In modern days, the consumer wants new products and new services. A
business should have a policy for promotion its products. Therefore, product policy,
sales promotion and market strategy are important aspects of business economics.
DEMAND ANALYSIS
Demand in terms of economics may be explained as the consumers’
willingness and ability to purchase or consume a given item/good.
“Demand means the various quantities of goods that would be purchased per
time period at different prices in a given market.” -Hibdon

DEMAND FUNCTION
Demand function is a mathematical expression of functional relationship
between determinants (price, income etc. determining variables) and the amount of
demand of a given product.
Demand function can be expressed as follows.
D=F( Px, Py, T, Y, E )
Where,
D=Demand
F= Function
Px= Prices of substitutes goods
Py= Prices of complementary goods
T= Taste & preference of the consumers
Y= Income of the consumers and
E= Consumer’s Expectations

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DETERMINANTS OF DEMAND

1. Price of the Product

The price of a product is the most important determinant of market demand in

the long-run and the only determinant in the short-run. As per the law of demand, the
price of a product and its quantity demanded are inversely related, i.e. the quantity
demanded increases when the price falls and decreases when the price raises, other
things remaining the same.

2. Price of related Goods

The market demand for a commodity is also affected by the changes in the
price of the related goods. The related goods may be the substitute and
complementary goods.
• Substitute goods-Two commodities are said to be a substitute for one another
if they satisfy the same want of an individual. Ex: tea and coffee, Maggi and
Yippie, Pepsi and Coca-Cola are close substitutes for each other.

• Complementary goods- A commodity is said to be a complement for another

if the use of two goods goes together such that their demand changes
(increases or decreases) simultaneously. Ex: bread and butter, car and petrol,
mattress and cot, etc. are complementary goods.

3. Consumers Income

The income is the basic determinant of the quantity demanded of a product as

it decides the purchasing power of the consumers. Thus, people with higher
disposable income spend a larger amount of income on consumer goods and
services as compared to those with lower disposable income.
4. Consumer’s Tastes and Preferences
Consumer’s Tastes and preferences play a vital role in determining a demand
for a product. Tastes and preferences often depend on the lifestyle, culture, and
hobbies of the consumers and the religious sentiments attached to a commodity.
The change in any of these factors results in the change in the consumer’s tastes and
preferences, thereby resulting in either increase or decrease in the demand for a
product.
5. Advertisement Expenditure
Advertisement is done to promote sales of a product. It helps in stimulating
demand for a product in four ways; by informing the prospective consumers about the
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availability of a product, by showing its superiority over the competitor’s brand, by
influencing the consumer’s choice against the rival product and by setting new fashion
and changing tastes of the consumers.
6. Consumer’s Expectation
In the short run, the consumer’s expectation with respect to the income, future
prices of the product and its supply position plays a vital role in determining the
demand for a commodity.
7. Demonstration Effect
Often, the new commodities or new models of an existing product are bought
by the rich people. Some people buy goods due to their genuine need for them or
have excess purchasing power. While some others do so because they want to exhibit
their influence.
8. Consumer Credit Facility
The availability of credit to the consumer also determines the demand for a
product. The credit extended by sellers, banks, friends, relatives or from other sources
induces a consumer to buy more than what would have not been possible in the
absence of the credit.
9. Population of the Country
The population of the country also determines the total domestic demand for a
product of mass consumption. For a given level of per capita income, tastes and
preferences, price, income, etc., the larger the size of the population the larger the
demand for a product and vice-versa.
10. Distribution of National Income
The national income is one of the basic determinants of the market demand for
a product, such as the higher the national income, the higher the demand for all the
normal goods.
LAW OF DEMAND
The Law of Demand asserts that there is an inverse relationship between the
price, and the quantity demanded, such as when the price increases the demand for
the commodity decreases and when the price decreases the demand for the
commodity increases, other things remaining unchanged.
DEFINITION OF LAW OF DEMAND
According to Prof. Samuelson , defined as "The law of demand states that
people will buy more at lower prices and buy less at higher prices, other things
remaining the same".
The law of demand can be further illustrated by the Demand Schedule and
the Demand Curve.

DEMAND SCHEDULE
The demand schedule is a tabular presentation of series of prices arranged in
some chronological order, i.e. either in ascending or descending order along with their
corresponding quantities which the consumers are willing to purchase per unit of time.
A hypothetical daily demand schedule for the commodity (Wheat) is given below:

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PRICE OF WHEAT/KG WHEAT DEMANDED BY FAMILY/DAY
(IN KG)
15 2
14 3
13 4
12 5
11 6
10 7
9 8

The table clearly illustrates the law of demand, i.e. the demand for wheat
increases as its price decreases. For example, at price Rs 14/kg only 3 kg of wheat is
demanded, but as the price decreases to Rs 13/kg the quantity demanded increased
to 4 kg.
Demand Curve: Demand curve is formed when the demand and price data in the
demand schedule is plotted on a graph. Thus, the demand curve is the graphical
representation of the demand schedule. The above demand schedule is represented
graphically in the figure below:

The DD’ is the demand curve that depicts the law of demand. The demand
curve is downward sloping towards the right, which shows that as the price of the
wheat decreases the quantity demanded increases.
LAW OF DEMAND – ASSUMPTIONS
While plotting the demand curve the following assumptions are to be taken into
the consideration:
• No change in price of related commodities.

• No change in income of the consumer.

• No change in taste and preferences, customs, habit and fashion of the consumer.

• No change in size of population

• No expectation regarding future change in price.

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LAW OF DEMAND –EXCEPTIONS
• Giffen Goods
• Veblen Goods
• The expectation of Price Change
• Speculative Demand
• Necessary Goods and Services and
• Fear of Shortage
Giffen Goods
Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods
are goods that are inferior in comparison to luxury goods. However, the unique
characteristic of Giffen goods is that as its price increases, the demand also increases.
The Irish Potato Famine is a classic example of the Giffen goods concept. Potato is a
staple in the Irish diet.
Veblen Goods
The second exception to the law of demand is the concept of Veblen goods.
Veblen Goods is a concept that is named after the economist Thorstein Veblen.
According to Veblen, there are certain goods that become more valuable as their price
increases. If a product is expensive, then its value and utility are perceived to be
more, and hence the demand for that product increases. Ex: Gold, Diamonds and
luxury cars such as Rolls-Royce. As the price of these goods increases, their demand
also increases because these products then become a status symbol.
The expectations of Price Change
There are times when the price of a product increases and market conditions
are such that the product may get more expensive. In such cases, consumers may
buy more of these products before the price increases any further. Consequently,
when the price drops or may be expected to drop further, consumers might postpone
the purchase to avail the benefits of a lower price.
Speculative Demand
In a speculative market (such as the stock market), a rise in the price of a
commodity (such as, share) creates an impression among buyers that its price will
rise further. So people start buying more of a share when its price rises.
Necessary Goods and Services
Another exception to the law of demand is necessary or basic goods. People will
continue to buy necessities such as medicines or basic staples such as sugar or salt
even if the price increases. The prices of these products do not affect their associated
demand.
Fear of Shortage
When people feel that a commodity is going to be scarce in the near future,
they buy more of it even if there is a current rise in price. Ex: If the people feel that
there will be shortage of L.P.G. gas in the near future, they will buy more of it, even if
the price is high.
ELASTICITY OF DEMAND
“Alfred Marshall” was the first economist to introduce the concept of elasticity of
demand into economic theory. “Elasticity of demand is the responsiveness of the
quantity demanded of a commodity to changes in one of the variables on which
demand depends”. In other words, “it is the percentage change in quantity demanded
divided by the percentage in one of the variables on which demand depends.”

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 Elasticity of demand Ed=

Price Elasticity of Demand: The price elasticity of demand, commonly known

as the elasticity of demand refers to the responsiveness and sensitiveness of
demand for a product to the changes in its price. In other words, the price
elasticity of demand is equal to

Income Elasticity of Demand: The income is the other factor that influences the
demand for a product. Hence, the degree of responsiveness of a change in demand for
a product due to the change in the income is known as income elasticity of demand.
The formula to compute the income elasticity of demand is:

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Cross Elasticity of Demand: The cross elasticity of demand refers to the change in
quantity demanded for one commodity as a result of the change in the price of
another commodity. Ex: substitutes and complementary goods. The cross elasticity of
demand for goods X and Y can be expressed as:

Advertising Elasticity of Demand: The responsiveness of the change in demand to

the change in advertising or rather promotional expenses is known as advertising
elasticity of demand. In other words, the change in the demand as a result of the
change in advertisement and other promotional expenses is called as the advertising
elasticity of demand. It can be expressed as:

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TYPES OF INCOME ELASTICITY OF DEMAND
1. High Income Elasticity of Demand
2. Unitary Income Elasticity of Demand
3. Low Income Elasticity of Demand
4. Negative Income Elasticity of Demand
5. Zero Income Elasticity of Demand

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 1. High Income Elasticity of Demand

2. Unitary Income Elasticity of Demand

3. Low Income Elasticity of Demand

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4. Negative Income Elasticity of Demand

5. Zero Income Elasticity of Demand

DEMAND FORECASTING
Demand Forecasting is the process in which historical sales data is used to
develop an estimate of an expected forecast of customer demand.

I. Survey method

Consumer’s survey method of demand forecasting involves direct interview of

the potential consumers. Consumers are simply contacted by the interviewer and
asked how much they would be willing to purchase of a given product at a number of
alternative product price levels.

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 i. Survey of Buyer’s Intentions

In survey of buyer’s intentions method, the buyers are contacted either directly
or by post with a questionnaire to elicit their opinions about a particular product or
service.
a. Census Method

The Census Method is also called as a Complete Enumeration Survey

Method wherein each and every item in the universe is selected for the data
collection. The census method is most commonly used by the government in
connection with the national population, housing census, agriculture census, etc.
b. Sample Method

A sampling method is a procedure for selecting sample members from a

population. A limited number of buyers chosen by sample are contacted, it is called
sample method.
ii. Survey of Sales Force Opinion Method
Sales forecasting technique is that predicts future sales by analyzing the
opinion of sales people as a group. Sales people continuously interact with customers,
and from this interaction they usually develop a knack for predicting future sales.
II. Statistical Methods
Statistical methods are complex set of methods of demand forecasting. These
methods are used to forecast demand in the long term. In this method, demand is
forecasted on the basis of historical data and cross-sectional data.
i. Trend Projection Method

Trend projection or least square method is the classical method of business

forecasting. In this method, a large amount of reliable data is required for forecasting
demand. In addition, this method assumes that the factors, such as sales and
demand, responsible for past trends would remain the same in future. In this method,
sales forecasts are made through analysis of past data taken from previous year’s
books of accounts.
ii. Barometric Techniques
In barometric method, demand is predicted on the basis of past events or key
variables occurring in the present. This method is also used to predict various
economic indicators, such as saving, investment, and income. This technique helps in
determining the general trend of business activities.
iii. Simultaneous Equations Method

Under simultaneous equation model, demand forecasting involves the

estimation of several simultaneous equations. This method employs several
mathematical and statistical tools of estimation. In the simultaneous equations
method, all variables are simultaneously considered as it is assumed that every
variable influences the other variables in an economic environment.
iv. Correlation and Regression Methods

Correlation and regression methods are statistical techniques. Correlation

describes the degree of association between two variables such as sales and
advertisement expenditure. For ex: if the sales have gone up as a result of increase

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in advertisement expenditure, we can say that the sales and advertisement are
positively correlated.
Regression Analysis
Past data is used to establish a functional relationship between two variables.
For example, demand for consumer goods has a relationship with income of
Individuals and family; demand for tractors is linked to the agriculture income and
demand for cement, bricks etc. are dependent upon value of construction contracts at
any time.
III. Other Methods
i. Expert Opinion Method

An expert is good at forecasting and analysing the future trends in a given

product or service at a given level of technology. An expert, who is associated with
the insights of the industry as a whole, is invited to suggest about the future of a
particular product or service.
ii. Test Marketing

The test marketing is the most reliable method of sales forecasting wherein the
product is launched in a few selected cities/town to check the response of customers
towards the product.
iii. Controlled Experiments
Controlled experiments, as the name itself suggests, the company can
experiment different homogeneous markets releasing its product with different types
of appeal such as different prices, packaging, models and so on in different markets or
same markets to assess which combination appeals to the customer most.
iv. Judgmental Approach
In the judgmental approach where none of the above methods are suitable to
assess demand for a particular product or service, the only alternative is to use one’s
judgment. Therefore, that different methods have different assumptions and criteria,
it is desirable that management should supplement its judgement to the results of
every method of demand forecasting.

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