Managerial Economics Managerial Economics Douglas - “Managerial economics is.. the application of economic principles and methodologies to the decision-making process within the firm or organization.” Douglas - “Managerial economics is.. the application of economic principles and methodologies to the decision-making process within the firm or organization.”

Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.” Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”

Positive Economics:- Positive Economics:- Derives useful theories with testable propositions about WHAT IS. Derives useful theories with testable propositions about WHAT IS. Normative Economics:- Normative Economics:- Provides the basis for value judgements on economic outcomes.WHAT SHOULD BE Provides the basis for value judgements on economic outcomes.WHAT SHOULD BE

Scope of Managerial Economics Utility analysis Utility analysis Demand and supply analysis Demand and supply analysis Production and cost analysis Production and cost analysis Market analysis Market analysis Pricing Pricing Investment decisions Investment decisions Game theory Game theory

Basic problems of an economy What to produce( Choice) What to produce( Choice) How to produce ( Technology) How to produce ( Technology) Whom to produce ( Distribution) Whom to produce ( Distribution)

Fundamental Concepts Managerial Economics Marginal Principle Marginal Principle Opportunity cost principle Opportunity cost principle Incremental Principle Incremental Principle Discount Principle Discount Principle Time Perspective Time Perspective

Demand Analysis Demand – Demand – Desire + ability to pay + willingness to pay Desire + ability to pay + willingness to pay Demand is relative term – Price Price Time Time Place Place

Determinants of demand Price Price Income Income Taste, preference and fashion Taste, preference and fashion Prices of related goods Prices of related goods Government policy Government policy Custom and tradition Custom and tradition Advertisement Advertisement

Law of demand If other things remain constant, when price increases demand contracts and when price decreases demand expands. Price and demand are inversely proportionate. If other things remain constant, when price increases demand contracts and when price decreases demand expands. Price and demand are inversely proportionate. D = a - bP D = a - bP

Why demand curve slopes downwards Law of diminishing marginal utility Law of diminishing marginal utility Income effect Income effect Substitution effect Substitution effect Multiplicity of uses Multiplicity of uses

Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Shows the amount of a good that will be purchased at alternative prices. Law of Demand Law of Demand The demand curve is downward sloping. The demand curve is downward sloping. Quantity D Price

Exception to the law of demand Giffen Goods Giffen Goods Prestigious goods Prestigious goods Buyers illusions Buyers illusions Necessary goods Necessary goods Brand loyalty Brand loyalty

Elasticity Elasticity is a measure of responsiveness of one variable to another variable. Elasticity is a measure of responsiveness of one variable to another variable. Can involve any two variables. Can involve any two variables. An elastic relationship is responsive. An elastic relationship is responsive. An inelastic relationship is unresponsive. An inelastic relationship is unresponsive.

Types of Elasticity of demand Price Elasticity of demand Price Elasticity of demand Income elasticity of demand Income elasticity of demand Cross Elasticity of demand Cross Elasticity of demand Promotional Elasticity of demand Promotional Elasticity of demand

Price elasticity:  p =%  Q/%  P Causality: denominator numerator! Causality: denominator numerator! An elastic response is one where numerator is greater than denominator. An elastic response is one where numerator is greater than denominator. i.e., %  Q>%  P so E p  i.e., %  Q>%  P so E p  Imagine extreme example. Imagine extreme example. An inelastic response is one where numerator is smaller than denominator. An inelastic response is one where numerator is smaller than denominator. i.e., %  Q<%  P so E p  i.e., %  Q<%  P so E p  Again, imagine extreme example. Again, imagine extreme example.

Look at the Extremes Perfectly Elastic D Perfectly Elastic D E p  infinite E p  infinite Perfectly Inelastic D P Q P Q Ep 0Ep 0 D D

Relatively Elastic vs. Inelastic Demand Curves Q1Q1 Q2Q2 Q2’Q2’ P1P1 P2P2 D’ D D’ is relatively more elastic than D P Q

Point Elasticity Formula Point elasticity Point elasticity Point elasticity is responsiveness at a point along the demand function Point elasticity is responsiveness at a point along the demand function E p  Q/Q 1 E p  Q/Q 1  P/P 1  P/P 1simplifying: E p  Q/  P)* P 1 /Q 1 Price (Rs.) Q Q1Q1 P1P1 D

Point Elasticity Formula Point elasticity Point elasticity Point elasticity is responsiveness at a point along the demand function Point elasticity is responsiveness at a point along the demand function E p  Q/Q 1 E p  Q/Q 1  P/P 1  P/P 1simplifying: E p  Q/  P)* P 1 /Q 1 Price (Rs.) Q Q1Q1 P1P1 D

Example: Q= *P Point elasticity Point elasticity E p  Q/  P)* P 1 /Q 1 Suppose P=17000 Suppose P=17000 Q= *17000 Q= *17000 Q=56-34=22 Q=56-34=22 Plug into equation gives: Plug into equation gives: E p  )* /22 E p =-34/22=-1.54 Price (Rs) Q 22 17k D

Arc Elasticity Briefly, arc elasticity is simply an average elasticity along a range of the demand curve.

Arc Elasticity Formula Arc elasticity: Arc elasticity: Responsiveness along a range of D. function Responsiveness along a range of D. function E p  Q/((Q 1 + Q 2 )/2) E p  Q/((Q 1 + Q 2 )/2)  P/((P 1 + P 2 )/2)  P/((P 1 + P 2 )/2)simplifying: E p  Q/  P)*((P 1 +P 2 )/(Q 1 +Q 2 )) Price ($) Q Q2Q2 P2P2 P1P1 Q1Q1 Avg. responsiveness D

Example Q= *P Arc elasticity Arc elasticity E p  Q/  P)*((P 1 +P 2 )/(Q 1 +Q 2 )) Look at P range 16k - 17k Look at P range 16k - 17k Q= *17000 Q= *17000 Q=56-34=22 Q=56-34=22 Plug into equation gives: Plug into equation gives: E p  )*(33000/46) E p =-66/46=-1.43 Price ($) Q 22 17k D 24 16k

Factors influence Price elasticity of demand Nature of commodity Nature of commodity Availability of substitute Availability of substitute Multiplicity of uses Multiplicity of uses Habit Habit Proportion of income spent Proportion of income spent Price range Price range

Managerial Applications of Price elasticity of demand Pricing Decision Pricing Decision Fiscal policy Fiscal policy Labour market Labour market International trade International trade

Income Elasticity of Demand Recall demand function is: Recall demand function is: Q=f(P,I,P related,Tastes,Buyers,Expectations...) Change in I causes shift in demand. Change in I causes shift in demand. Size of shift depends on income elasticity. Size of shift depends on income elasticity. E I  Q/  I E I  Q/  I Focus again on point formula. Focus again on point formula. Value of E I determines type of good. Value of E I determines type of good.

Values for Income Elasticity (   ) Sign indicates normal or inferior Sign indicates normal or inferior  E I  >0 implies normal good. E I <0 implies inferior good. E I <0 implies inferior good. Normal goods may be necessity or luxury. Normal goods may be necessity or luxury. If E I >1 then this is luxury (responsive to income). If E I >1 then this is luxury (responsive to income). If 0<E I <1 then this is necessity (unresponsive to income). If 0<E I <1 then this is necessity (unresponsive to income).

Cross Price Elasticity (E XY ) Q X =f(P X,I,P Y,Tastes, Buyers,Expectations...) Change in P Y causes shift in demand for X. Change in P Y causes shift in demand for X. Size of shift depends on cross-price elasticity. Size of shift depends on cross-price elasticity. E XY  Q X /  P Y E XY  Q X /  P Y Sign indicates relationship between two goods Sign indicates relationship between two goods  E XY >0 implies goods are substitutes. E XY <0 implies goods are complements. E XY <0 implies goods are complements.

OBJECTIVES OF SHORT TERM DEMAND FORECASTING Production planning Production planning Evolving sales policy Evolving sales policy Fixing sales targets Fixing sales targets Determining price policy Determining price policy Inventory control Inventory control Determining short-term financial planning Determining short-term financial planning

OBJECTIVES OF LONG-TERM DEMAND FORECASTING BUSINESS PLANNING BUSINESS PLANNING MANPOWER PLANNING MANPOWER PLANNING LONG-TERM FINANCIAL PLANNING LONG-TERM FINANCIAL PLANNING

METHODS OF DEMAND FORECASTING Survey methods : Consumer interviews Consumer interviews Opinion poll Opinion poll Experts opinion Experts opinion End-use method End-use method Statistical methods: Trend Analysis Trend Analysis Regression Analysis Regression Analysis

Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply Law of Supply The supply curve is upward sloping The supply curve is upward sloping Price Quantity S0S0

Supply Shifters Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

The Supply Function An equation representing the supply curve: An equation representing the supply curve: Q x S = f(P x, P R,W, H,) Q x S = quantity supplied of good X. Q x S = quantity supplied of good X. P x = price of good X. P x = price of good X. P R = price of a related good P R = price of a related good W = price of inputs (e.g., wages) W = price of inputs (e.g., wages) H = other variable affecting supply H = other variable affecting supply

Change in Quantity Supplied Price Quantity S0S B A 5 A to B: Increase in quantity supplied

Price Quantity S0S0 S1S S 0 to S 1 : Increase in supply Change in Supply 6

Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. The amount producers receive in excess of the amount necessary to induce them to produce the good. Price Quantity S0S0 Producer Surplus Q*Q* P*P*

Market Equilibrium Balancing supply and demand Balancing supply and demand Q x S = Q x d Q x S = Q x d Steady-state Steady-state

Price Quantity S D 8 Equilibrium Price and quantity 7

Price Quantity S D Shortage = 6 6 If price is too low... 7

Price Quantity S D 9 14 Surplus = If price is too high… 7