Managerial Economic Bba Unit -i 6p2k5u

LESSON – 1 NATURE & SCOPE OF MANAGERIAL ECONOMICS The Managerial Economics and Business Economics are often used interchangeably. However, the Managerial Economics has become more popular and seems to displace Business Economics. DECISION-MAKING AND FORWARD PLANNING The chief function of a management executive in a business firm is decision-making and forward planning. Decision-making refers to the process of selecting one action from two or more alternative courses of action. Forward planning on the other hand is arranging plans for the future. In the functioning of a firm the question of choice arises because the available resources such as capital, land, labour and management, are limited and can be employed in alternative uses. The decision-making function thus involves making choices or decisions that

will

provide

the

most

efficient

means

of

attaining

an

organisational objectives, for example profit maximization. Once a decision is made about the particular goal to be achieved, plans for the future regarding production, pricing, capital, raw materials and labour are prepared. Forward planning thus goes hand in hand with decision-making. The conditions in which firms work and take decisions, is characterised with uncertainty. And this uncertainty not only makes the function of decision-making and forward planning complicated but also adds a different dimension to it. If the knowledge of the future were perfect, plans could be formulated without error and hence without any need for subsequent revision. In the real world,

however,

the

business

manager

rarely

has

complete

information about the future sales, costs, profits, capital conditions. etc. Hence, decisions are made and plans are formulated on the basis of past data, current information and the estimates about future that are predicted as accurately as possible. While the plans are

implemented over time, more facts come into the knowledge of the businessman. In accordance with these facts the plans may have to be revised, and a different course of action needs to be adopted. Managers are thus engaged n a continuous process of decisionmaking through an uncertain future and the overall problem that they deal with is adjusting to uncertainty. To execute the function of „decision-making in an uncertain frame-work‟, economic theory can be applied with considerable advantage. Economic theory deals with a number of concepts and principles relating to profit, demand, cost, pricing, production, competition, business cycles and national income, which are aided by allied disciplines like ing. Statistics and Mathematics also can be used to solve or at least throw some light upon the problems of business management. The way economic analysis can be used towards solving business problems constitutes the subject matter of Managerial Economics. DEFINITION According to McNair the Merriam, Managerial Economics consists of the use of economic modes of thought to analyse business situations. Spencer and Siegelman have defined Managerial Economics as “the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.” The above definitions suggest that Managerial economics is the discipline, which deals with the application of economic theory to business management. Managerial Economics thus lies on the margin between economics and business management and serves as the bridge between the two disciplines. The following Figure 1.1 shows the relationship

between

managerial economics.

economics,

business

management

and

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT The application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects : 

Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions: In economic theory, the technique of analysis is that of model building. This involves making some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, make the theory of the firm

unrealistic

since

it

fails

to

provide

a

satisfactory

explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions

with

actual

business

practice

and

develop

appropriate extensions and reformulation of economic theory. For example, it is usually assumed that firms aim at maximising profits. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. In practice, however, firms do not always aim at maximum profits (as they may think of diversifying or introducing new product etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm‟s actual behavior. Moreover, in actual

business language, certain like profits and costs have ing concepts as distinguished from economic concepts. In managerial economics, an attempt is made to merge the ing concepts with the economics, an attempt is made to merge the ing concepts with the economic concepts. This helps in a more effective use of financial data related to profits and costs to suit the needs of decision-making and forward planning. 

Estimating

economic

relationships:

This

involves

the

measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity and cost-output relationships. The estimates of these economic relationships are to be used for the purpose of forecasting. 

Predicting relevant economic quantities: Economic quantities such as profit, demand, production, costs, pricing and capital are

predicated

in

numerical



together

with

their

probabilities. As the business manager has to work in an environment of uncertainty, the future needs to be foreseen so that in the light of the predicted estimates, decision-making and forward planning may be possible. 

Using economic quantities in decision-making and forward planning: This involves formulating business policies for establishing future business plans. This nature of economic forecasting indicates the degree of probability of various possible outcomes, i.e., losses or gains that will occur as a result of following each one of the available strategies. Thus, a quantified picture gets set up, that indicates the number of courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, the business manager is able to decide about which strategy should be chosen.



Understanding significant external forces: Applying economic theory to business management also involves understanding the

important external forces that constitute the business environment and with which a business must adjust. Business cycles, fluctuations in national income and government policies pertaining to

taxation,

foreign

trade,

labour

relations,

antimonopoly

measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies. CHARACTERISTICS OF MANAGERIAL ECONOMICS There are certain chief characteristics of managerial economics, which can help to understand the nature of the subject matter and help in a clear understanding of the following : 

Managerial economics is micro-economic in character. This is because the unit of study is a firm and its problems. Managerial economics does not deal with the entire economy as a unit of study.



Managerial economics largely uses that body of economic concepts and principles, which is known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to apply profit theory, which forms part of distribution theories in economics.



Managerial economics is concrete and realistic. I avoids difficult abstract issues of economic theory. But it also involves complications ignored in economic theory in order to face the overall situation in which decisions are made. Economic theory ignores the variety of backgrounds and training found in individual

firms.

Conversely,

managerial

economics

is

concerned more with the particular environment that influences decision-making. 

Managerial economics belongs to normative economics rather than positive economics. Normative economy is the branch of economics in which judgments about the desirability of various policies are made. Positive economics describes how the

economy behaves and predicts how it might change. In other words, managerial economics is prescriptive rather than descriptive. It remains confined to descriptive hypothesis. 

Managerial economics also simplifies the relations among different

variables

without

judging

what

is

desirable

or

undesirable. For instance, the law of demand states that as price increases, demand goes down or vice-versa but this statement does not imply if the result is desirable or not. Managerial decisions

economics, ought

to

however,

be

made

is and

concerned hence

with

what

involves

value

judgments. This further has two aspects: first, it tells what aims and objectives a firm should pursue; and secondly, how best to achieve

these

economics,

aims

therefore,

in

particular

has

been

situations.

described

as

Managerial normative

microeconomics of the firm. 

Macroeconomics is also useful to managerial economics since it provides

an

intelligent

understanding

of

the

business

environment. This understanding enables a business executive to adjust with the external forces that are beyond the management‟s control but which play a crucial role in the well being of the firm. The important forces are: business cycles, national income ing, and economic policies of the government like those relating to taxation foreign trade, antimonopoly measures and labour relations. DIFFFFERENCE

BETWEEN

MANAGERIAL

ECONOMICS

AND

ECONOMICS The difference between managerial economics and economics can be understood with the help of the following points: 

Managerial

economics

involves

application

of

economic

principles to the problems of a business firm whereas; economics deals with the study of these principles only. Economics ignores the application of economic principles to the problems of a business firm.



Managerial economics is micro-economic in character, however, Economics is both macro-economic and micro-economic.



Managerial economics, though micro in character, deals only with a firm and has nothing to do with an individual‟s economic problems. But microeconomics as a branch of economics deals with both economics of the individual as well as economics of a firm.



Under microeconomics, the distribution theories, viz., wages, interest and profit, are also dealt with. Managerial economics on the contrary is mainly concerned with profit theory and does not consider other distribution theories. Thus, the scope of economics is wider than that of managerial economics.



Economic theory assumes economic relationships and builds economic models. Managerial economics adopts, modifies and reformulates the economic models to suit the specific conditions and

serves

the

specific

problem

solving

process.

Thus,

economics gives the simplified model, whereas managerial economics modifies and enlarges it. 

Economics involves the study of certain assumptions like in the law of proportion where it is assumed that “The variable input as applied, unit by unit is homogeneous or identical in amount and quality”. Managerial economics on the other hand, introduces certain s. These s are in the form of objectives of the firm, multi-product nature of manufacture, behavioral constraints, environmental aspects, legal constraints, constraints on resource availability, etc. Thus managerial economics, attempts to solve the complexities in real life, which are assumed in economics. this is done with the help of mathematics, statistics, econometrics, ing, operations research, etc.

OTHER FOR MANAGERIAL ECONOMICS

Certain other expressions like economic analysis for business decisions and economics of business management have also been used instead of managerial economics but they are not so popular. Sometimes expressions like „Economics of the Enterprise‟, „Theory of the Firm‟ or „Economics of the Firm‟ have also been used for managerial economics. It is, however, not appropriate t use theses because managerial economics, though primarily related to the economics of the firm, differs from it in the following respects: 

First, „Economics of the Firm‟ deals with the theory of the firm, which is a body of economic principles relating to the firm alone. Managerial economics on the other hand deals with the, application of the same principles to business.



Secondly, the term „Economics of the firm‟ is too simple in its assumptions whereas managerial economics has to reckon with actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS As regards the scope of managerial economics, there is no general uniform pattern. However, the following aspects may be said to be inclusive under managerial economics: 

Demand analysis and forecasting.



Cost and production analysis.



Pricing decisions, policies and practices.



Profit management.



Capital management. These aspects may also be defined as the „Subject-Matter of

Managerial Economics‟. In recent years, there is a trend towards integrations of managerial economics and operations research. Hence, techniques such as linear programming, inventory models and theory of games have also been regarded as a part of managerial economics. Demand Analysis and Forecasting

A business firm is an economic Organisation, which transforms productive resources into goods that are to be sold in a market. A major part of managerial decision-making depends on accurate estimates of demand. This is because before production schedules can be prepared and resources are employed, a forecast of future sales is essential. This forecast can also guide the management in maintaining or strengthening the market position and enlarging profits. The demand analysis helps to identify the various factors influencing demand for a firm‟s product and thus provides guidelines to manipulate demand. Demand analysis and forecasting, thus, is essential for business planning and occupies a strategic place in managerial

economics.

It

comprises

of

discovering

the

forces

determining sales and their measurement. The chief topics covered in this are: 

Demand determinants



Demand distinctions



Demand forecasting.

Cost and Production Analysis A study of economic costs, combined with the data drawn from the firm‟s ing records, can yield significant cost estimates. These estimates are useful for management decisions. The factors causing variations in costs must be recognised and thereby should be used for taking management decisions. This facilitates the management to arrive at cost estimates, which are significant for planning purposes. An element of cost uncertainty exists in this because all the factors determining costs are not always known or controllable. Therefore, it is essential to discover economic costs and measure them for effective profit planning, cost control and sound pricing practices. Production analysis is narrower in scope than cost analysis. The chief topics covered under cost and production analysis are: 

Cost concepts and classifications



Cost-output relationships



Economics of scale



Production functions



Cost control.

Pricing Decisions, Policies and Practices Pricing is a very important area of managerial economics. In fact price is the origin of the revenue of a firm. As such the success of a usiness firm largely depends on the accuracy of price decisions of that firm. The important aspects dealt under area, are as follows: 

Price determination in various market forms



Pricing methods



Differential pricing product-line pricing and price forecasting.

Profit Management Business firms are generally organised with the purpose of making profits. In the long run, profits provide the chief measure of success. In this connection, an important point worth considering is the element of uncertainty existing about profits. This uncertainty occurs because of variations in costs and revenues. These are caused by factors such as internal and external. If knowledge about the future were perfect, profit analysis would have been a very easy task. However, in a world of uncertainty, expectations are not always realised. Thus profit planning and measurement make up the difficult area of managerial economics. The important aspects covered under this area are: 

Nature and measurement of profit.



Profit policies and techniques of profit planning.

Capital Management Among the various types and classes of business problems, the most complex and troublesome for the business manager are those relating to the firm‟s capital investments. Capital management implies planning and control and capital expenditure. In this procedure, relatively large sums are involved and the problems are so complex that their disposal not only requires considerable time and labour but

also

top-level

decisions.

The

main

elements

dealt

with

cost

management are: 

Cost of capital



Rate of return and selection of projects.

The various aspects outlined above represent the major uncertainties, which a business firm has to consider viz., demand uncertainty, cost uncertainty,

price

uncertainty,

profit

uncertainty

and

capital

uncertainty. We can, therefore, conclude that managerial economics is mainly concerned with applying economic principles and concepts to adjust with the various uncertainties faced by a business firm. USES OF MANAGERIAL ECONOMICS Managerial economics achieves several objectives. The principal objectives are as follows: 

It presents those aspects of traditional economics, which are relevant for business decision-making in real life. For this purpose, it picks from economic theory those concepts, principles and techniques of analysis, which are concerned with the decision-making process. These are adapted or modified in such a way that it enables the manager to take better decisions. Thus, managerial economics attains the objective of building a suitable tool kit from traditional economics.



Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc. If they are found relevant for decision-making. In fact, managerial economics takes the aid of other academic disciplines that are concerned with the business decisions of a manager in view of the various explicit and implicit constraints subject to which resource allocation is to be optimised.



It helps in reaching a variety of business decisions even in a complicated environment. Certain examples of such decisions are those decisions concerned with: o The products and services to be produced o The inputs and production techniques to be used

o The quantity of output to be produced and the selling prices to be subscribed o The best sizes and locations of new plants o Time of replacing the equipment o Allocation of the available capital 

Managerial economics helps a manager to become a more competent model builder. Thus, he can pick out the essential relationships, which characterise a situation and leave out the other unwanted details and minor relationships.



At the level of the firm, functional specialists or functional departments

exist,

e.g.,

finance,

marketing,

personnel,

production etc. For these various functional areas, managerial economics serves as an integrating agent by co-ordinating the different areas. It then applies the decisions of each department or specialist, those implications, which are pertaining to other functional areas. Thus managerial economics enables business decision-making to operate not with an inflexible and rigid but with an integrated perspective. This integration is important because the functional departments or specialists often enjoy considerable autonomy and achieve conflicting goals.Managerial economics keeps in mind the interaction between the firm and society and accomplishes the key role of business as an agent in attaining social economic welfare. There is a growing awareness that besides its obligations to shareholders, business enterprise has certain social obligations as well. Managerial economics focuses on these social obligations while taking business decisions. By doing so, it serves as an instrument of furthering the economic welfare of the society through socially oriented business decisions. Thus, it is evident that the applicability and usefulness of managerial economics is obtained by performing the following activates: 

Borrowing and adopting the tool-kit from economic theory.



Incorporating relevant ideas from other disciplines to achieve better business decisions.



Serving as a catalytic agent in the course of decision-making by different functional departments/specialists at the firm‟s level.



Accomplishing a social purpose by adjusting business decisions to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS Economic theory offers a variety of concepts and analytical tools that can assist the manager in the decision-making practices. Problem solving in business has, however, found that there exists a wide disparity between the economic theory of a firm and actual observed practice, thus necessitating the use of many skills and be quite useful to examine two aspects in this regard: 

The basic tools of managerial economics which it has borrowed from economics, and



The nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.

Basic Economic Tools in Managerial Economics The most significant contribution of economics to managerial economics lies in certain principles, which are basic to the entire range of managerial economics. The basic principles may be identified as follows: 1. Opportunity Cost Principle The opportunity cost of a decision means the sacrifice of alternatives required by that decision. This can be best understood with the help of a few illustrations, which are as follows: 

The opportunity cost of the funds employed in one‟s own business is equal to the interest that could be earned on those funds if they were employed in other ventures.



The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment.



The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products.



The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.



If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.



If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in of the ratio of their respective prices, say Px/Py.



The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil. For decision-making, opportunity costs are the only relevant

costs. The opportunity cost principle may be stated as under: “The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.” Thus in macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to national fund for buying armour has cost the nation of losing an opportunity of buying more butter. Similarly, a continued diversion of funds towards defence

spending, amounts to a heavy tax on alternative spending required for growth and development. 2. Incremental Principle The incremental concept is closely related to the marginal costs and marginal revenues of economic theory. Incremental concept involves two important activities which are as follows: 

Estimating the impact of decision alternatives on costs and revenues.



Emphasising the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision.

The two basic components of incremental reasoning are as follows: 

Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.



Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.

The incremental principle may be stated as under: A decision is obviously a profitable one if: o It increases revenue more than costs o It decreases some costs to a greater extent than it increases other costs o It increases some revenues more than it decreases other revenues o It reduces costs more that revenues. Some businessmen hold the view that to make an overall profit, they must make a profit on every job. Consequently, they refuse orders that do not cover full cost (labour, materials and overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be inconsistent with profit maximisation in the short run. A refusal to accept business below full cost may mean rejection of a possibility of adding more to revenue than cost. The relevant cost is not the full cost but rather the incremental cost. A simple problem will illustrate this point.

IIIustration Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are estimated as under: Labour

Rs. 1,500

Material

Rs. 2,000

Overhead (Allocated at 120% of labour cost)

Rs. 1,800

Selling istrative expenses (Allocated at 20% of labour and material cost)

Rs.

700

Total Cost

Rs. 6,000

The order at first appears to be unprofitable. However, suppose, if there is idle capacity, which can be, utilised to execute this order then the order can be accepted. If the order adds only Rs. 500 of overhead (that is, the added use of heat, power and light, the added wear and tear on machinery, the added costs of supervision, and so on), Rs. 1,000 by way of labour cost because some of the idle workers already on the payroll will be deployed without added pay and no extra selling and istrative cost then the incremental cost of accepting the order will be as follows. Labour

Rs. 1,500

Material

Rs. 2,000

Overhead

Rs.

Total Incremental Cost

Rs. 3,500

500

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does not mean that the firm should accept all orders at prices, which cover merely their incremental costs. The acceptance of the Rs. 5,000 order depends upon the existence of idle capacity and labour that would go unutilised in the absence of more profitable opportunities. Earley‟s study of “excellently managed” large firms suggests that progressive corporations do make formal use of incremental analysis. It is,

however, impossible to generalise on the use of incremental principle, since the observed behaviour is variable. 3. Principle of Time Perspective The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short-run and long-run effects of decisions on revenues as well as on costs. The actual problem in decision-making is to maintain the right balance between the long-run and short-run considerations. A decision may be made on the basis of short-run considerations, but may in the course of time offer long-run repercussions, which make it more or less profitable than it appeared at first. An illustration will make this point clear. IIIustration Suppose there is a firm with temporary idle capacity. An order for 5,000 units comes to management‟s attention. The customer is willing to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more. The short-run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per unit (Rs. 5,000 for the lot. However, the long-run repercussions of the order ought to be taken into are as follows: 

If the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient

capacity

to

take

up

business

with

higher

contributions when the opportunity arises. The management may be compelled to consider the question of expansion of capacity and in such cases; even the so-called fixed costs may become variable. 

If any particular set of customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated. In response, they may opt to patronise manufacturers with

more decent views on pricing. The reduction or prices under conditions of excess capacity may adversely affect the image of the company in the minds of its clientele, which will in turn affect its sales. It is, therefore, important to give due consideration to the time perspective. The principle of time perspective may be stated as under: „A decision should take into both the short-run and long-run effects on revenues and costs and maintain the right balance between the long-run and short-run perspectives.” Haynes, Mote and Paul have cited the case of a printing company. This company pursued the policy of never quoting prices below full cost though it often experienced idle capacity and the management was fully aware that the incremental cost was far below full cost. This was because the management realised that the long-run repercussions of pricing below full cost would make up for any shortrun gain. The management felt that the reduction in rates for some customers might have an undesirable effect on customer goodwill particularly among regular customers not benefiting from price reductions. It wanted to avoid crating such an “image” of the firm that it exploited the market when demand was favorable but which was willing to negotiate prices downward when demand was unfavorable. 4. Discounting Principle One of the fundamental ideas in economics is that a rupee tomorrow is worth less than a rupee today. This seems similar to the saying that a bird in hand is worth two in the bush. A simple example would make this point clear. Suppose a person is offered a choice to make between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will choose the Rs. 100 today. This is true for two reasons. First, the future is uncertain and there may be uncertainty in getting Rs. 100 if the present opportunity is not availed of. Secondly, even if he is sure to receive the gift in future, today‟s Rs. 100 can be invested so as to earn interest, say, at 8 percent so that. one year after the Rs. 100 of today will become Rs.

108 whereas if he does not accept Rs. 100 today, he will get Rs. 100 only in the next year. Naturally, he would prefer the first alternative because he is likely to gain by Rs. 8 in future. Another way of saying the same thing is that the value of Rs. 100 after one year is not equal to the value of Rs. 100 of today but less than that. To find out how much money today is equal to Rs. 100 would earn if one decides to invest the money. Suppose the rate of interest is 8 percent. Then we shall have to discount Rs. 100 at 8 per cent in order to ascertain how much money today will become Rs. 100 one year after. The formula is: Rs. 100 V=

1+i

where, V = present value i = rate of interest. Now, applying the formula, we get Rs. 100 V=

1+i 100

=

1.08

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money, which will accumulate at 8 per cent after one year. 92.59 x 1.08 = 99.0072 = 1.00 The same reasoning applies to longer periods. A sum of Rs. 100 two years from now is worth: Rs. 100 V=

(1+i)2

Rs. 100 =

(1.08)2

Rs. 100 =

1.1664

Similarly, we can also check by computing how much the cumulative interest will be after two years. The principle involved in the above discussion is called the discounting principle and is stated as follows: “If a decision affects costs and revenues at future dates, it

is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.” 5. Equi-marginal Principle This principle deals with the allocation of the available resource among the alternative activities. According to this principle, an input should be allocated in such a way that the value added by the last unit is the same in all cases. This generalisation is called the equimarginal principle. Suppose a firm has 100 units of labour at its disposal. The firm is engaged in four activities, which need labour services, viz., A, B, C and D. It can enhance any one of these activities by adding more labour but sacrificing in return the cost of other activities. If the value of the marginal product is higher in one activity than another, then it should be assumed that an optimum allocation has not been attained. Hence it would, be profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. For example, if the values of certain two activities are as follows: Value of Marginal Product of labour Activity A = Rs. 20 Activity B = Rs. 30 In this case it will be profitable to shift labour from A to activity B thereby expanding activity B and reducing activity A. The optimum will be reach when the value of the marginal product is equal in all the four activities or, when in symbolic : VMPLA = VMPLB = VMPLC = VMPLD Where the subscripts indicate labour in respective activities. Certain

aspects

of

the

equi-marginal

principle

need

clarifications, which are as follows: 

First, the values of marginal products are net of incremental costs. In activity B, we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50

paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20. 

Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will make them equivalent.



Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity requires an alternative reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price.



Fourthly,

the

equi-marginal

principle

may

break

under

sociological pressures. For instance, du to inertia, activities are continued simply because they exist. Similarly, due to their empire building ambitions, managers may keep on expanding activities to fulfil their desire for power. Department, which are already over-budgeted often, use some of their excess resources to build up propaganda machines (public relations offices) to win additional . Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES A managerial economist can play a very important role by assisting the management in using the increasingly specialised skills and sophisticated techniques, required to solve the difficult problems of successful decision-making and forward planning. In business concerns, the importance of the managerial economist is therefore recognised a lot today. In advanced countries like the USA, large companies employ one or more economists. In our country too, big industrial

houses

have

understood

the

need

for

managerial

economists. Such business firms like the Tatas, DCM and Hindustan Lever employ economists. A managerial economist can contribute to decision-making in business in specific . In this connection, two important questions need be considered: 1. What role does he play in business, that is, what particular management problems lend themselves to solution through economic analysis? 2. How can the managerial economist best serve management, that is, what are the responsibilities of a successful managerial economist? Role of a Managerial Economist

One of the principal objectives of any management in its decisionmaking process is to determine the key factors, which will influence the business over the period ahead. In general, these factors can be divided into two categories: 

External



Internal

The external factors lie outside the control of management because they are external to the firm and are said to constitute business environment. The internal factors lie within the scope and operations of a firm and hence within the control of management, and they are known as business operations. To illustrate, a business firm is free to take decisions about what to invest, where to invest, how much labour to employ and what to pay for it, how to price its products, and so on. But all these decisions are taken within the framework of a particular business environment, and the firm‟s degree of freedom depends on such factors as the government‟s economic policy, the actions of its competitors and the like. Environmental Studies of a Business Firm An analysis and forecast of external factors constituting general business conditions, for example, prices, national income and output, volume of trade, etc., are of great significance since they affect every business firm. Certain important relevant factors to be considered in this connection are as follows: 

The outlook for the national economy, the most important local, regional or worldwide economic trends, the nature of phase of the business cycle that lies immediately ahead.



Population shifts and the resultant ups and downs in regional purchasing power.



The demand prospects in new as well as established markets. Impact of changes in social behaviour and fashions, i.e., whether they will tend to expand or limit the sales of a company‟s products, or possibly make the products obsolete?



The areas in which the market and customer opportunities are likely to expand or contract most rapidly.



Whether overseas markets expand or contract and the affect of new foreign government legislations on the operation of the overseas plants?



Whether the availability and cost of credit tend to increase or decrease buying, and whether money or credit conditions ahead are likely to easy or tight?



The prices of raw materials and finished products.



Whether the competition will increase or decrease.



The main components of the five-year plan, the areas where outlays have been increased and the segments, which have suffered a cut in their outlays.



The outlook to government‟s economic policies and regulations and changes in defence expenditure, tax rates tariffs and import restrictions.



Whether the Reserve Bank‟s decisions will stimulate or depress industrial production and consumer spending and how will these decisions affect the company‟s cost, credit, sales and profits.

Reasonably accurate data regarding these factors can enable the management to chalk out the scope and direction of their own business plans effectively. It will also help them to determine the timing of their specific actions. And it is these factors, which present some of the areas where a managerial economist can make effective contribution. The managerial economist has not only to study the economic trends at the micro-level but also must interpret their relevance to the particular industry or firm where he works. He has to digest

the

ever-growing

economic

literature

and

advise

top

management by means of short, business-like practical notes. In mixed economy like that of India, the managerial economist pragmatically interprets the intentions of controls and evaluates their impact. He acts as a bridge between the government and the industry,

translating the government‟s intentions and transmitting the reactions of the industry. In fact, the government policies emerge out of the performance of industry, the expectations of the people and political expediency. Business Operations A managerial economist can also be helpful to the management in making decisions relating to the internal operations of a firm in respect of such problems as price, rate of operations, investment, expansion or contraction. Certain relevant questions in this context would be as follows: 

What will be a reasonable sales and profit budget for the next year?



What will be the most appropriate production schedules and inventory policies for the next six months?



What changes in wage and price policies should be made now?



How much cash will be available next month and how should it be invested?

Specific Functions The managerial economists can play a further role, which can cover the following specific functions as revealed by a survey pertaining to Brittain conducted by K.J.W. Alexander and Alexander G. Kemp: 

Sales forecasting.



Industrial market research.



Economic analysis of competing companies.



Pricing problems of industry.



Capital projects.



Production programmes.



Security / Investment analysis and forecasts.



Advice on trade and public relations.



Advice on primary commodities.



Advice on foreign exchange.



Economic analysis of agriculture.



Analysis of underdeveloped economics.



Environmental forecasting.

The managerial economist has to gather economic data, analyse all relevant information about the business environment and prepare position papers on issues facing the firm and the industry. In the case of industries prone to rapid theological advances, the manager may have to make continuous assessment of tl1e impact of changing technology. The manager' may need to evaluate the capital budget in the light of short and long-range financial, profit and market potentialities. Very often, he also needs to prepare speeches for the corporate executives. It is thus clear that in practice, managerial economists perform many and various functions. However, of all these, the marketing functions, i.e., sales force listing an industrial market research, are the most important. For this purpose, the managers may collect statistical records of the sales performance of their own business and those rehiring to their rivals, carry out analysis of these records and report on trends in demand, their market shares, and the relative efficiency of their retail outlets. Thus, while carrying out heir functions, the managers may have to undertake detailed statistical analysis. There are, of course, differences in the relative importance of· the various functions performed from firm to firm and in the degree of sophistication of the methods used in performing these functions. But there is no doubt that the job of a managerial economist requires alertness and the ability to work uriderpressure.

Economic Intelligence Besides these functions involving sophisticated analysis, managerial

economist may also provide general intelligence service. Thus the economist may supply the management with economic information of general interest such as competitors prices and products, tax rates, tariff rates, etc. Participating in Public Debates Many well-known business economists participate in public debates. The government and society alike are seeking their advice and views. Their practical experience in business and industry adds prestige to their views. Their public recognition enhances their protégé in the .firm itself. Indian Context In the Indian context, a managerial economist is expected to perform the following functions:  Macro-forecasting for demand and supply.  Production planning at macro and micro levels.  Capacity planning and product-mix determination.  Economics of various production lines.  Economic feasibility of new production lines / processes and projects.  Assistance in preparation of overall development plans.  Preparation of periodical economic reports bearing on various matters such as the company's product-lines, future growth opportunities, market pricing situation, general business,. and various national/international factors affecting industry and business.  Preparing

briefs;

speeches,

articles

and

papers

for

top

management for various chambers, Committees, Seminars, Conferences, etc Keeping management informed of various national and International Developments on economic/industrial matters. With the adoption of the new economic policy, the macro-

economic environment is changing fast and these changes have tremendous implications for business. The managerial economists have to playa much more significant role. They ha'1e to constantly measure the possibilities of translating the rapidly changing economic scenario into workable business opportunities. As India marches towards globalisation, the managerial economists will have to interpret the global economic events and find out how the firm can avail itself of the various export opportunities or of establishing plants abroad either wholly owned or in association with local partners. Responsibilities of a Managerial Economist Besides considering the opportunities that lie before a managerial economist it is necessary to take into the services that are expected by the management. For this, it is necessary for a managerial economist to thoroughly recognise the responsibilities and obligations. A managerial economist can serve the management best by recognising that the main objective of the business, is to make a profit on its invested capital. Academic training and the critical comments from people outside the business may lead a managerial economist to adopt an apologetic or defensive attitude towards profits. There should be a strong personal conviction on part of the managerial economist that profits are essential and it is necessary to help enhance the ability of the firm to make profits. Otherwise it is difficult to succeed in serving management. Most management decisions necessarily concern the future, which is rather uncertain. It is, therefore, absolutely essential that a managerial

economist

recognises

his

responsibility

to

make

successful forecast. By making the best possible forecasts and through constant efforts to improve, a managerial' ng, the risks involved in uncertainties. This enables the management to· follow a more orderly course of business planning. At times, it is required for the managerial economist to reassure the management that an important trend will continue. In other cases, it is necessary to point

out the probabilities of a turning point in some activity of importance to management. In any case, managerial economist must be willing to make

fairly

positive

developments.

These

statements can

be

about

based

impending

upon

the

economic

best

possible

information and analysis. The management's confidence in a managerial economist increases more quickly and thoroughly with a record of successful forecasts, well documented in advance and modestly evaluated when the actual results become available. A few consequences to the above proposition need also be emphasised here.  First, a managerial economist has a major responsibility to alert managelI1ent at the earliest possible moment in' case there is an err6r' in his forecast. This will assist the mallagement in making appropriate

adjustment

in

policies

and

programmes

and

strengthen his oWn position as a member of the management team by keeplrighis fingers on the economic pulse of the business.  Secondly, a managerial economist must establish and maintain many s with individuals and data sources: which would not be immediately available to the other of the management. Extensive familiarity with reference sources and material is essential. It is still more important that the known individuals who are specialists in particular fields have a bearing on tpe managerial economist's work. For this purpose, it is required

that

managerial

economist

s

professional

associations and tak~ active part in them. In fact, one of the best means of determining the quality of a managerial economist is to evaluate his ability to obtain information quickly by personal s rather than by lengthy research from either readily available or obscure reference sources. Within any business, there' may be a wealth of knowledge and experience but the managerial economist would be really useful ifit is possible pn

his part to supplement the existing know-how with additional information and in the quickest possible manner. Again, if a managerial economist is to be really helpful to the management in successful decision-making and forward planning, it is necessary'" to able to earn full status on the business team. Readiness to take up special assignments, be that in study teams, committees or special projects is another important requirement. This is because it is necessary for the managerial economist to win continuing for himself and his professional ideas. Clarity of expression terminology

and

attempting

while

to

minimise

communJcating

his

the

use

ideas

to

of

technical

management

executives is also an essential role so as to win approval. To conclude, a managerial economist has a very important role to play by helping management in successful decision-making and forward planning. But to discharge his role successfully, it is necessary to recognise the 'relevant responsibilities and obligations. To some business executives, however, a managerial economist is still a luxury or perhaps even a necessary evil. It is not surprising, therefore, to find that while tneir status is improving and their impor;ance is gradually rising, managerial economists in certain firms still 'feel quite insecure. Nevertheless, there is a definite and growing realisation that they can contribute significantly to the profitable growth of firms and effective solution oftMir problems, and this' promises them a positive future.

LESSON – 2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of any business firm. Firms are interested in their profit and sales, both of which depend partially upon the demand for the product. The decisions, which management makes with respect to production, advertising, cost allocation, pricing, inventory holdings, etc. call for an analysis of demand. While how much a firm can produce depends upon its capacity and demand for its products. If there is no demand for a product, its production is unworthy. If demand falls short of production, one way to balance the two is to create new demand through more and better ments. The more the future demand for a product, the more inventories the firm would hold. The larger the demand for a firm's product, the higher is the price it can charge. Demand analysis seeks to identify and measure the forces that determine sales. Once this is done the alternative ways of manipulating or managing demand can easily be inferred. Although, demand for a finri's product reflects what the consumers buy, this can be influenced through manipulating the factors on which consumers base their demands. Demand analysis attempts to estiinate the demand for a product in future, which further helps to plan production based on the estimated demand. MEANING OF DEMAND Demand for a good implies the desire of an individual to acquire the product. It also includes willingness and ability of ail individual to pay for the product. For example, a miser's desire for and his ability to pay for a car is not demand, for he does not have the necessary will to pay for the car. Similarly, a poor person's desire for· and his

willingness to pay for a car is not demand because he lacks the necessary purchasing power. One can also imagine an individual, who possesses both the will and the purchasing power to pay for a good. But this purchasing power is not the demand for that good, this is because he does not have the desire to buy that product. Therefore, demand is successful when there are all the three factors: desire, willingness and ability. It should also be noted that demand for any goods or services has no meaning unless it is stated with reference to time, price, competing product, consumer's incomes, tastes and preferences. This is because demand varies with fluctuations in these factors. For example, the demand for an Ambassador car in India is 40,000 is meaningless unless it is stated that this was the demand ·in 1976 when an Ambassador car's price was around thirty thousand rupees. The price of the competing cars‟ prices were around the same, a Bajaj scooter's price was around five thousand rupees and petrol price was around three and a half rupees per litre. In 1977, the demand for Ambassador cars could be different if any of the above factors happened to be different. Furthermore, it should be noted that a product is defined with reference to its particular quality. If its quality changes it can be deemed as another product. Thus, the demand for any product is the desire, wi1lihigness and ability to buy the product with reference to a partkular time and given values of variables on which it depends.

TYPES OF DEMAND The demand for various kinds of goods is generally classified on the basis of kinds of consumers, suppliers of goods, nature of goods, duration of consumption goods, interdependence of demand, period of demand and nature of use of goods (intermediate or final), The major classifications of demand are as follows:  Individual and market demand

 Demand for firm's prodtictand industry's products  Autonomous and derived demand  Demand for durable and non-durable goods  Short-term and long-term demand Individual and Market Demand The quantity of a product, which an individual is willing to buy at a particular price during a specific time period, given his money income, his taste, and prices of other commodities (particularly substitutes and complements), is called 'individual's demand for a product'. The total quantity, which all comsumers are willing to buy at a given price per time unit, given their money income, taste, and prices of other commodities is known as 'market demand for the good'. In other words, the market demand for a good is the sum of the individual demands of all the c6-nsumers of a product, over a time period at given prices.

Demand for Firm's Product and Industry's Products The quantity of a firm's yield, that can be disposed of at a given price over a period refers to the demand for firm's product. The aggregate demand for the product of all firms of an industry is known as the market-demand or demand for industry's product. This distinction between the two kinds of demand is not of much use in a highly competitive market since it merely signifies the distinction between a sum and its parts. However, where market structure is oligopolistic, a distinction between the demand for firm's product and industry's product is useful from managerial point of view. The product of each firm is so differentiated from the products of the rival firms that consumers treat each product different from the other. This gives firms an opportunity to plan the price of a product, it in order to capture a larger market share thereby to enhance profits. For instance, market of cars, radios, TV sets, refrigerators, scooters, toilet soaps and toothpaste, all belong to this category of markets.

In case of monopoly and perfect competition, the distinction between demand for a firm's product and industry's product is not of much use from managerial point of view. In case of monopoly, industry is one-firmindustiy andthe demand for firm's product is the same as that of the industry. In case of perfect competition, products of all firms .of the industry are homogeneous and price for each firm is determined by industry. Firms have little opportunity to plan

the

prices

permissible

under

local

conditions

and

ment by a firm becomes effective for the whole industry. Therefore, conceptual distinction between demand for film's product and industry's product is not much use in business decisions making. Autonomous and Derived Demand An

Autonomous

demand

for

a

product

is

one

that

arises

independently of the demand for any other good whereas a derived demand is one, which is derived from demand of some other good. To look more closely at the distinction between the two kinds of demand, consider the demand for commodities, which arise directly from the biological or physical needs of the human beings, such as demand for food, clothes and shelter. The demand for these goods is autonomous demand.

Autotnomous

demand

also

arises

as

a'

result

of

demonstration effect, rise in income, and increase in population and ment of new produCts. On the other hand, the demand for a good that arises because of the demand for some other good is called derived demand. For instance, demand for land, fertiliser and agricultural tools and implements are derived demand, since the demand of goods, depends on the demand of food. Similarly, demand for steel, bricks, cement etc., is a derived demand because it is derived from the demand for houses and other kind of buildings. [n general, the demand for, producer goods or industrial inputs is a derived one. Besides, demand for complementary goods (which complement the use of other goods) or for supplementary goods

(which supplement or provide additional utility from the use of other goods) is a derived demand. For instance petrol is a complementary goods for automobiles and a chair is a complement to a table. Consider some examples of supplement goods. Butter is supplement to bread, mattress is supplement to cot and sugar is supplement to tea. Therefore, demand for petrol, chair, and sugar would be considered as derived demand. The conceptual distinction between autonomous demand and derived demand would be useful according to the point of view of a bllsinessman to the extent the former can serve as an indicator of the latter. Demand for Durable and Non-durable Goods Demand is often classified under demand for durable and non-durable goods. Durable goods are those goods whose total utility is not exhausted in single or short-run use. Such goods can be used continuously over a period of time. Durable goods may be consumer goods as well as producer goods. Durable consumer goods include clothes, shoes, house furniture, refrigerators, scooters, and cars. The durable producer goods include mainly the items under fixed assets, such as building, plant and machinery, office furniture and fixture. The durable goods, both consumer and producer goods, may be further classified as semi-durable goods such as, clothes and furniture and durable goods such as residential and factory buildings and cars. On the other harid, non-durable goods are those goods, which can be used only once such as food items and their total utility is exhausted in a single use. This category of goods can also be grouped under non-durable consumer and producer goods. All food items such as drinks, soap, cooking fuel, gas, kerosene, coal and cosmetics fall in the former category whereas, goods such as raw materials', fuel and power, finishing materials and packing items come in the latter category. The demand for non-durable goods depends largely on their current prices, consumers' income and fashion whereas the expected

price, income and change in technology influence the demand for the durable good. The demand for durable goods changes over a relatively longer period. There is another point of distinction between demands for durable and non-durable goods. Durable goods create demand for replacement or substitution of the goods whereas non-durable goods do not. Also the demand for non-durable goods increases or decreases with a fixed or constant rate whereas the demand for durable goods increases or decreases exponentially, i.e., it may depend· upon some factors such as obsolescence of machinery, etg. For example, let us suppose that the annual demand for cigarettes in a city is 10 million packets and it increases at the rate of half-a-million packets per annum on of increase in population when other factors remain constant. Thus, the total demand for cigarettes in the next year will be 10.5 million packets and 11 million packets in the next to next year and so on. This is a linear increase in the demand for a nondurable good like cigarette. Now consider the demand for a durable good, e.g., automobiles. Let us suppose: (i1 the existing number of automobiles in a city, in a year is 10,000, (ii) the annual replacement demand equals 10 per cent of the total demand, and (iii) the annual autonomous increase ·in demand is 1000 automobiles. As such, the total annual clemand for automobiles in four subsequent years is calculated and presented in Table 2.1. Table 2.1: Annual Demand for Automobiles Beginning Total no. of Replacement Annual Total Annual of the year automobiles demand autonomous demand increase (Stock) demand in ; , demand 1st year 10,000 10,000 2nd year

10,000

1000

1000

2000

1000

12,000 _ 14,200

-3id year

12,000

1200

4th year

14,200

1420

1000

16,620

2420

2200

Stock + Replacement + Autonomous demand = TotalDemand It may be seen from the Table 2.1 that the total demand for automobiles is increasing at an increasing rate due to acceleration

in the replacement demand. Another factor, which might accelerate the demand for automobiles and such durable goods, is the rate of obsolescence of this category of goods. Short-term and Long-term Demand Short-term demand refers to the demand for goods that are demanoed over a short period. In this category fall mostly the fashion consumer goods, goods of seasonal use and inferior substitutes during the scarcity period of superior goods. For instance, the demand for fashion wears is short-term demand though the demand for the generic goods such as tros, shoes and ties continues to remain a longterm

demand.

Similarly,

demand

for

umbrella,

raincoats,

gumboots, cold drinks and ice creams is of seasonal nature; 'The demand for such goods lasts till the season lasts. Some goods of this category are demanded for a very short period, i.e., 1-2 week, for example, new greeting cards, candles and crackers on occasion of diwali. Although some goods are used only seasonally but are durable in pature, e.g., electric fans, woollen garments, etc. The demand for such goods is of also durable in nature but it is subject to seasonal fluctuations. Sometimes, demand for certain gools suddenly increases because of scarcity of their superior substitutes. For examp1e, when supply of cooking gas suddenly decreases, demand for kerosene, cooking coal and charcoal increases. In such cases, additional demand is of shGrtterm nature. The long-term demand, on the hand, refers to the demand, which exists over a long-period. The change in long-term demand is visible only after a long period. Most generic goods have long-term demand. For example, demand for consumer and producer goods, durable and non-durable goods, is long-term demand, though their different varieties or brands may have only short-term demand. Short-term demand depends, by and large, on the price of commodities, price of their substitutes, current disposable income of the consumer, their ability to adjust their consumption

pattern and their susceptibility to ment of a new product. The long-term demand depends on the long-term income trends, availability of better substitutes, sales promotion, and consumer credit facility. The short-term and lcmg-term concepts of demand are useful in deg new products for established producers, choice of products for the new entrepreneurs, in pricing policy and in determining ment expenditure. DETERMIN!\NTS OF MARKET DEMAND The knowledge of the determinants of market demand for a product and the nature of relationship between the demand and its determinants proves very helpful in analysing and estimating demand for the product. It may be noted at the very outset that a host of factors determines the demand for a product. In general, following factors determine market demand for a good: 

Price of the good- .



Price of the related goods-substitutes, complements and supplements



Level of consumers' income



Consumers' taste and preference

ment of the product 

Consumers' expectations about future price and supply position



Demonstration effect and 'bend-wagon effect‟



Consumer-credit facility

 Population of the country  Distribution pattern of national income. These factors also include factors such as off-season discounts and gifts on purchase of a good, level of taxation and general social and political environment of the country. However, all these factors are

not

equally

quantifiable.

For

important. example,

Besides,

some

consumer's

of

them

preferences,

are

not

utility,

demonstration effect and expectations, are difficult to measure.

However, both quantifiable and non-quantifiable determinants of demand for a product will be discussed. 1. Price of the Product The price of a product is one of the most important determinants of demand in the long run and the only determinant in the short run. The price and quantity demanded are inversely related to each other. The law of demand states that the quantity demanded of a good or a product, which its consumers would like to buy per unit of time, increases when its price falls, and decreases when its price increases, provided the other factors remain' same. The assumption 'other factors remaining same' implies that income of the consumers, prices of the substitutes and complementary goods, consumer's taste and preference and number of consumers remain unchanged. The pricedemand relationship assumes a much greater significance in the oligopolistic market in which outcome of price war between a firm and its rivals determines the level of success of the firm. The firms have to be fully aware of price elasticity of demand for their own products and that of rival firm's goods.

2. Price of the Related Goods or Products The demand for a good is also affected by the change in the price of its related goods. The related goods may be the substitutes or complementary goods. Substitutes Two goods are said to. be substitutes of each other if a change in price of one good affects the deinand for the other in the same direction. For instance goods X and Y are considered as substitutes for each other if a rise in the price of X increase demand for Y, and vice versa. Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some examples of substitutes in case of consumer goods by definition, the relation between demand for a product and price of its substitute is of positive nature. When, price of the substitute of a product (tea) falls (or

increase), the demand for the product falls (or increases). The relationship of this nature is shown in Figure 2.1 and 2.2.

Complementary Goods A good is said to be a complement for another when it complements the use of the other or when the two goods are used together in such a way

that

their

demand

changes

(increases

or

decreases)

simultaneously. For example, petrol is a complement to car and scooter, butter and jam to bread, milk and sugar to tea and 1 coffee, mattress to cot, etc. Two goods are termed as complementary to each other -i if an increase in the price of one causes a decrease in demand for the other. By definition, there is an inverse relation between the demand for a good and the price of its complement. For instance, an

increase in the price of petrol causes a decrease in the demand for car and other petrol-run vehicles and vice versa while other thing's remaining constant. The nature of relationship between the demand for a product and the price of its complement is given in Figure 2.2. 3. Consume's Income Income is the basic determinant of market demand since it determines the purchasing power of a consumer. Therefore, people with higher current disposable income spend a larger amount on goods and services than those with lower income. Income-demand relationship is of more varied nature than that between demand and its other determinants. While other determinants of demand, e.g., product's own price and the price ohts substitutes, are more significant in the short-run, income as a determinant of demand is equally important in both short run and long run. Before proceeding further to discuss income-demand relationships, it will be useful to note that consumer goods of different nature have different kinds of relationship with consumers having different levels of income. Hence, the managers need to be fully aware of the kinds of goods they are dealing with and their relationship with the income of consumers, particularly about the assessment of both existing and prospective demand for a product. For the purpose of income-demand analysis, goods and serv:ices maybe grouped under four broad categories, which ate: (a) essential consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige or luxury goods. To understand all these , it is essential to understand the relationship between income and different kinds of goods. Esscntial Consumcr Goods (ECG): The goods and services of this category are called 'basic needs' and are consumed by all persons of a society such as food-grains, salt, vegetable oils, matches, cooking fuel, a minimum clothing and housing. Quantity demanded for these goods increases with increase in

consumer's income but only up to certain limit, even though the total expenditure may increase in accordance with the quality of goods consumed, other factors remaining the same. The relationship between goods of this category and consumer's income is shown by the curve ECG in Figure 2.3. As the curve shows, consumer's demand for essential goods increases only until his income rises to OY2. It tends to saturate beyond this level of income. Inferior goods: Inferior goods are those goods whose demand decreases with the increase in consumer's income. For example millet is inferior to wheat and rice; bidi (indigenous cigarette) is inferior to cigarette, coarse, textiles are inferior to refined ones, kerosene is inferior to cooking gas and travelling by bus is inferior to travelling by taxi. The relation between income and demand for an inferior good is shown by the curve IG in Figure 2.3 under the assumption that other determinants of demand remain the same demand for such goods rises only up to a certain level of income, i.e., OY1 and declines as income increases beyond this level.

Normal goods: Normal goods are those goods whose demand increases with increaseiri the consumer income. For example, clothings, household furniture and automobiles. The relation between income and demand for normal goods is shown by the curve NG in Figure 2.3. As the curve shows, demand for such goods increases with the increases in consumer income but at different rates at different levels of income. Demand for normal goods increases rapidly with the increase in the consumer's income but slows down with further increase in income. It should be noted froms Figure 2.3 that up to certain level of income (YI) the relation between income and demand for all type of goods is similar. The difference is of only degree. The relation becomes distinctly different beyond YI level of income. Therefore, it is important to view the income-demand relations in the light of the nature of product and the level fconsumer's income.  Prestige and luxury goods: Prestige goods are those goods, which are consu!TIed mostly by rich section of the society, e.g., precious stones, antiques, rare paintings, luxury cars and such other items of show-bff. Whereas luxury goods include jewellery, costly brands of cosmetics, TV sets, refrigerators, electrical gadgets and cars. Demand for such goods arises beyond a certain level of consumer's income, i.e., consumption enters the area of luxury goods. Producers of such goods, while assessing the demand for their goods, should consider the income changes in the richer section of the society and not only the per capita income. The relation between income and demand for such goods is shown by the curve LG in Figure 2.3.

4. Consumer's taste and preference Consumer's taste and preference play an important role in detennihing demand for a product. Taste and preference depend, generally, on the changing. life-style, social customs, religious values attached to a good, habi of the people, the general levels of living of the society and age and sex

of the consumers. Change in these factors changes consumer's taste and preferences. As a result, consumers reduce or give up the consumption of some goods and add new ones to their consumption pattern. For example, following the change in fashion, people switch their consumption pattern from cheaper, old-fashioned goods to costlier „mod‟ goods, as long as price differentials are proportionate with their preferences. Consumers are prepared to pay higher prices for 'mod goods' even if their virtual utility is the same as that of old-fashioned goods. The manufacturers of goods and services that are subject to frequent change in fashion and style, can take advantage of this situation in two ways: (i) they can make quick profits by deg new models of their goods and popularising them through ment, and (ii) they can plan production in abetter way and can even avoid over-productiorlifthey keep an eye on the changing fashions. 5. l11ent Expenditure ment costs are incurred with the objective of increasing the demand for the goods. This is done in the following ways:  By informing the potential consumers about the availability of the goods.  By showing its superiority to the rival goods.  By influencing consumers' choice against the rival goods, and  By setting fashions and changing tastes. The impact of such effects shifts the demand curve upward to the right. In other words, when other factors' remain same, the expenditure on ment increases the volume of sales to the same extent. The relation between ment outlay and sales is shown in Figure 2.4.

Assumptions Therelatiqnship between demand and ment cost as shown in Figure 2.4 is based on the following assumptions: 

Consumers are fairly sensitive and responsive to various modes of ment.



The rival firms do not react to the ments made by a firm.



The level of demand has not already reached the saturation point. ment beyond this point will make only marginal impact on demand.



Per unit cost of ment added to the price does not make the price prohibitive for consumers, as compared particularly to the price of substitutes.



Others determinants of demand, e.g., income and tastes, etc., are not operating in the reverse direction.

In the absence of these conditions, the ment effect on sales may be unpredictable. 6. Consumers’ Expectations Consumers‟ expectations regarding the future prices, income and supply position of goods play an important role in determining the demand for goods and services in the short run. If consumers expect a rise in the price

of a storable good, they would buy more of it at its current price with a view to avoiding the possibility of price rise future. On the contrary, if consumers expect a fall in the price of certain goods, they postpone their purchase with a view to take advantage of lower prices in future, mainly in case of nonessential goods. This behaviour of consumers reduces the current demand for the goods whose prices are expected to decrease in future. Similarly, an expected increase in income increases the demand for a product. For example, announcement of „dearness allowance‟, bonus and revision of pay scale induces increase in current purchases. Besides, if scarcity of certain goods is expected by the consumers on of reported fall in future production, strikes on a large scale and diversion of civil supplies towards the military use causes the current demand for such goods to increase more if their prices show an upward trend. Consumer demand more for future consumption and profiteers demand more to make money out of expected scarcity. 7. Demonstration Effect When new goods or new models of existing ones appear in the market, rich people buy them first. For instance, when a new model of car appears in the market, rich people would mostly be the first buyer, Colour TV sets and VCRs were first seen in the houses of the rich families some people buy new goods or new models of goods because they have genuine need for them. Some others do so because they want to exhibit their affluence. But once new goods come in fashion, many households buy them not because they have a genuine need for them but because their neighbors have bought the same goods. The purchase made by the latter category of the buyers are made out of such feelings' as jealousy, competition, equality in the peer group, social inferiority and the desire to raise their social status. Purchases made on of these factors are the result of what economists call 'demonstration effect' or the 'Band-wagon-effect.' These effects have a positive effect on demand. On the contrary, when goods become the thing of common use, some people, mostly rich, decrease or give up the consumption of such goods. This is known as 'Snob Effect'. It

has a negative effect'on the demand for the related goods. 8. Consumer-Gredit Facility Availability of credit to the cansumers fram the sellers, banks, relatians and friends encourages the conSumers to buy more than what they would buy in the aosence of credit availability. Therefore, the consumers who can borrow more can consume more than those who cannot borrow. Credit facility affects mostly the demand"for durable goods, particularly those, which require bulk payment at the time of purchase. The car-loan facility may be one reason why Delhi has more cars than Calcutta, Chennai and Mumbai. Therefore, the managers who are assessing the prospective demand for their goods should take into the availability of credit to the consumers.

9. Population of the Country The Jotal domestic demand for a good of mass consumption depends also on the size' of the population. Therefore, larger the population larger will be the demand for a product, when price, per capita income, taste and preference are given. With an increase or decrease in the size of population, employment percentage remaining the same, demand for the product will either increase or decrease. 10. Distribution of National Income The level of national income is the basic determinant of the market demand for a good. Therefore, pig her the national income higher will be the demand for all normal goods and services. Apart from this, the distribution pattern of the national income is also an important determinant for demand of a good. If national income is evenly distributed, market demand for normal goods will be the largest. If national income is unevenly distributed, i.e., if majority of population belongs to the lower income groups, market demand for essential goods, including inferior ones, will be the largest whereas the demand for other kinds of goods will be relatively less.