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Managerial Economics

Managerial Economics

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Introduction to Managerial Economics

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SECTION 1

Introduction to Managerial Economics

Economics is the study of how economic agents, individually and collectively, make choices regarding the use of scarce resources that can often be put to different uses, in order to satisfy wants which are of relatively higher priority from among the unlimited wants they face. It is the study of how entities try to make the best possible use of the limited resources they have.

Economic analysis, like any other scientific analysis, can be either positive or normative. The analysis is positive when it describes how things are and how things will be. It is normative when the focus is on how things ought to be. Positive economics explains economic phenomena according to their causes and effects. It says nothing about what is right or wrong; it is not concerned with moral judgments. On the other hand, normative economics involves making

value judgments. There is a desired end which is deemed to be subjectively better than the alternat ives and normative economics is about using the right means to reach that desired end. A positive statement is based on facts. A normative statement involves ethical values.

Economics can be broadly divided into microeconomics and macroeconomics.

Microeconomics is the study of how individual economic units, be it an individual agent or household or firm, tries to optimize when faced with resource scarcity. Microeconomics studies economic decision-making from the perspective of households and firms; it focuses on the conduct of individual consumption and production units within a particular market structure. The broad framework of microeconomics revolves around the allocation of resources,

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Video 1.1.1: Introduction to Economics by Prof Dennis

Meyers

production and distribution of goods and services and consumption. Broadly, microeconomics deals with the consumer behavior, theory of demand and supply, theory of firm, pricing and market structure, and theory of distribution.

Microeconomics deals with consumption and production, and uses notions of surplus to explain a sense of economic well-being. Change in these measures are used to understand the overall implications of economic policies on the welfare of the people. Much of welfare economics is based on price theory as microeconomics also deals with how to minimize inefficiencies in allocation and production. When economic efficiency is improved, wastage of scarce resources is minimized, which has significant effects on improving economic welfare.

Macroeconomics deals with the overall performance of the economic system; it focuses on issues such as unemploy-ment, inflation, economic growth and other problems, which affect the economy as a whole. It deals with aggregates and the overall economic environment. The framework of macro-economics broadly covers sustained economic growth, price stability, growth and development, balance of payment, etc.

Manage- rial Eco-nomics

Managerial economics is the application of economic theory and decision science tools and techniques to the problems of

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Video 1.1.2: Micro Vs Macro Economics

Keynote 1.1.1: Differences Be-tween Micro & Macro Economics

managerial decision-making. While microeconomics provides theoretical framework and tools that help optimally utilize the firms resources, macroeconomics plays an important role by providing an understanding of the economic environment in which managerial decision-making takes place. To that extent, one can say that managerial economics is the application of microeconomic theory by practicing managers in running their business and developing it.

According to Dominic Salvatore, "Managerial Economics is the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its aim or objectives most efficiently.

Spencer and Siegelman define Managerial Economics as "The integration of economic theory with business practice for t h e purpose of

facilitating d e c i s i o n m a k i n g

a n d f o r w a r d p l a n n i n g

b y

management"

Managerial Economics is a discipline which integrates economic theory, decision science and fundamental areas of business administration. Managerial Economics thus serves as a bridge between economics and business management.

Theories are important for any science. Theories provide a framework for explaining reality and making predictions. There are several economic theories. Consumption Theory and the Theory of the Firm are two of the most important components of microeconomic theory.

A model is an abstraction or simplification of the real world, based on economic theory. A model with its assumptions is often analogous to the control experiments that are done in the basic sciences. These models may be explained in words, or with numerical tables, graphs or algebra.

Models often make use of assumptions. Most microeconomic theories assume that economic agents are rational and other factors, not in consideration, remain unchanged (Ceterius paribus). Such assumptions often may not hold true. However, if the model retains its predictive capacity, the invalidity of assumptions are not a matter of concern. Even in basic sciences, by definition, control factors in laboratory experiments may not remain the same outside the laboratory environment, but this does not make the experiment irrelevant in any fashion.

The science of economics renders a technical help to the manager in making optimal and rational economic decisions particularly in situation involving risk and uncertainty.

Keynote 1.1.2: Dimension of Mana-gerial Economics

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Nature and the Scope

Managerial economics helps the consumers and managers of a firm in reaching various managerial decisions such as decisions on buying different combinations of goods and services, what products and services to be produced, producing a level of output by using different combinations of inputs and techniques of production, how much output to be produced and at what price output to be sold, etc. It also helps the managers in taking marketing decision, cost decisions, advertisement decisions, budgetary decisions and investment decisions. Managerial economics deals in detail with the below-mentioned managerial decision problems faced by consumers and firms.

Thus managerial economics is the application of economic analysis in evaluating decisions having economic content and intent. Some of the business decisions which have economic content are as follows:

Profit Decision:

Profit maximization is assumed to be the most principal objective of any business firm. In reality, a firm may not aim for maximizing profit, but they do have a profit policy. The entrepreneur constantly examines the profit position of the company so as to take the corrective timely measures in an advance. Hence the decision concerning the level of profit and reinvestment of profit are relevant and in turn influences the business greatly. For instance, Managerial economics

explains rules for selecting the profit maximizing output for firms in all types of market structure - perfectly competitive market, monopoly, monopolistic competitive market, oligopoly market, etc.

Demand Decisions

Profits are functionally related to the volume of sales and the revenue earned thereby. Demand for the firms goods or services and revenues in turn depend on the nature of individual and market demand. Demand decision of the firm needs to take into account the nature and dynamics of demand for its goods or services and accordingly arrange the factor inputs to organize the production in efficient manner. As such, demand decisions which can be evaluated through an analysis of consumer behavior are crucial. Managerial economics helps an organization to understand how changes in price and income affect demand for their products and helps to take appropriate production decisions.

Production Decisions

Analysis of demand decisions is naturally followed by that of production decisions. Production function is a statement of technological relation between input and output. Any decision concerning output has, therefore, a natural bearing on the decisions concerning input. The business firm, whether it produces goods or services, has to decide about factor combinations and factor proportions. The choice of techniques of production, use of economies of scale and scope, and least cost combination constitutes the dimension of production decision. For an examination of such decisions,

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production analysis must be combined with loss analysis. Firms have to decide how much of each input to be used in producing its output given the resource constraint.

Price-Output Decisions

Profit decision depends on two attributes, i.e., cost of production and revenue received from the sale of the product. It can be further inferred from the cost of production attribute that at what price and in what quantity are the productive factors obtained from the factor market. From the second attribute we can infer the meaning that at what price and what quantity are the products sold in the commodity markets? Answers to such questions are possible through an analysis of the market structure, i.e., the form of competition which the business firm faces in the commodity and factor market.

Investment decisions

The investment decision is also part of the production and capital budgeting decision of the firm. If the firm is operating for the long haul, the firms capital needs to be arranged at the least cost so as to enjoy the financial economies of scale.

The various types of economic decisions taken by a business enterprise can be evaluated only through an extensive use of various types of economic analysis. Thus the scope of managerial economics tends to be wide. The main objective of managerial economics is the analysis of business decision of a firm with the help of microeconomic concepts, tools and techniques.

Thus Managerial economics is the application of economic theory and decision science tools and techniques to the problems of managerial decision-making. It helps the firm in reaching various managerial decisions such as profit decisions, demand decisions, production decisions, price-output decisions, marketing decisions and investment decisions for achieving optimal solutions.

The next chapter will throw light on the theory of demand and supply.

References

Positive and Normative Economics

Macro and Micro Economics

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8REVIEW 1.1

Check Answer

Question 1 of 4Who among the following supplies the various factors of production?

A. Households

B. Firms

C. Industry

D. Government

SECTION 2

Scarcity and Choice

Scarcity is what necessitates making choices. Problems of choice arise at all levels - at the individual level, at the household level, at the firm level and at the overall economy level. The challenge is to make choices that maximize the level of satisfaction, with the available resources.

The allocation of scarce resources between competing requirements is the main economic problem in any society. The individual also faces similar problems of choice as multiple wants have to be satisfied with a limited amount of money.

To ensure eff ic ient a l locat ion of resources, microeconomics advocates a free-market economy where demand and supply determine the allocation of resources. If demand is high for a particular product, and supply is less than

the demand, its price will increase. Producers in a market economy will automatically produce more of the product, to reap the profits from the higher price. Consequently, supply increases and prices drop till the point where there is neither shortage nor surplus in the market. Thus in a free market economy, there is no agency or intermediary planning or controlling the market or fixing the price. Instead, consumers and producers make their choices based on the market forces of demand and supply.

In market economies, both consumers and producers face trade-offs; trade-offs between consuming more and saving more or between earning more money and having more leisure.

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Video 1.2.1: Scarcity & Choice

It is important to remember that, in reality, markets may be competitive or non-competitive. Most benefits of market economy are benefits derived from competition. Since not all markets are equally competitive, the degree of economic efficiency which exists in various markets are likely to differ.

Opportunity Cost

The opportunity cost of using a resource is the benefit that one could have got had the resource been put to its next best possible alternative use. The opportunity cost is an important concept; by making a choice to produce one type of good, the next best alternative good cannot be produced. For the consumer, deciding to spend a certain amount of money on a particular good is also about deciding not to spend that amount on another good which satisfies some want. It should be obvious that if scarcity was not there, opportunity cost would hardly matter.

Consumers typically make their decisions based on two considerations - budget constraints and personal preferences. A budget constraint is the difficulty a person faces when he tries to satisfy his unlimited wants with a limited income. Since the budget constraint is a function of income and price, one can say that any purchase decision is based on income, price, and personal tastes and preferences.

A consumer can have a choice of alternative products with a limited income if he can find a person with whom he can exchange goods or services. By means of such exchanges, he can increase his level of satisfaction.

Such exchanges are also possible for producers. Although two producers may both be capable of producing two products, each can also choose to produce the one product in which she has a comparative advantage over the other and exchange products.

Fundamental Economic Problems

All societies face three fundamental economic problems which arise out of scarcity. These are questions about choices related to the use of scarce economic resources. They are:

What to produce?

At the societal level, scarcity of land, labor and capital implies that all the wants in the economy cannot be satisfied. Since all wants cannot be satisfied, society must determine which wants are more important at a given point in time. Accordingly, they have to choose which goods and services are to be produced with the limited resources available.

How to produce?

This is about choosing the combination of resources and the quantity of each resource to be used to produce a certain quantity and quality of output. From a societal perspective, the best combination is one which fully employs the available resources to produce the maximum output. Depending on the resources available, techniques of production may be labor intensive or capital intensive.

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For whom to produce?

This refers to the distribution of goods and services between different sections of the population. Scarce resources are to be used appropriately to cater to the needs of all income groups.

These three questions are indeed interrelated. A society, which decides to produce more of highly sophisticated aircrafts and less of cycles, is also deciding to use more of capital and less of labor. In turn, since aircraft mechanics are likely to belong to a much higher income group than, say, cycle mechanics, the decision to produce more aircrafts has direct implications on the distribution question as well.

Economic Systems

How these fundamental questions are answered will depend on the extent of government control on the economy. Based on the role of the government in addressing these questions, there are three broad types of economic systems in the world - the market economy, the command economy and the mixed economy.

Market Economy

In a market economy, the freedom of individuals as consumers and suppliers of resources, allows market forces to determine the allocation of scarce resources through the price mechanism. Based on market demand and supply, consumers are free to buy goods and services of their choice and producers allocate their resources based on the demand.

Decisions made by producers and consumers are influenced greatly by price. Any increase in the price of a product without a corresponding increase in cost increases profit; as a result, producers allocate more resources to that particular product. On the other hand, if consumers do not like to buy a product, supply would exceed demand and price would fall, resulting in a lower profit or even a loss to the producers.

Thus price plays a major role in a market economy. The role of the government is negligible: consumers choose the goods they want and producers allocate their resources based on the market demand for different products. The United States of America is an example of a market economy.

In the US, firms decide the type and quantity of goods to be made in response to consumer demand. An increase in the price of one good encourages producers to switch resources to the production of that item. Consumers decide the type and quantity of goods to be bought; a decrease in the price of one good encourages consumers to switch to buying that item.

Command Economy

In a command economy, answers to the three fundamental questions are decided by the government. So, what to produce, how to produce and for whom to produce are all decided by the people in power. The role of the government is all pervasive here, while consumer and producer choice is very limited. In this system, efficiency can be achieved only when demand is accurately forecasted and resources allocated accordingly. The former USSR was an example of a command economy. The government had complete control

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over the economy and consumers were just the price takers. The government set output targets and allocated the necessary resources. The biggest challenge for a command economy is the massive requirement of real-time economic data, far beyond the technological and infrastructural capabilities of any government anywhere today.

Mixed Economy

A mixed economy is an economic system, which combines the features of a free market economy and a command economy. While consumers and producers enjoy freedom and choice, the government usually sets limits to such freedom. Government controls price fluctuations beyond a range, whi le interfer ing in the economy in order to achieve a few set national goals. Mixed economies often have some unregulated sectors and some highly regulated sectors. Governments in mixed economies generally attempt to plan the course of their countries development and use cost-benefit analyses to answer the fundamental economic problems of what, how and for whom to produce. In principle, decisions or projects affecting the economy as a whole are taken or accepted only when the social benefits from the decision of project are greater than the social costs. Theoretically, a cost benefit analysis helps to assess the full costs and benefits to society arising from a particular decision or project, but sometimes in practice, the cost of collecting

and processing the massive amount of information required results in lags and inefficiencies.

In a mixed economy, often the government organizes the provision of certain goods and services such as education and health care, which are considered essential.

Production Possibility Curve

The production possibility curve (PPC) helps us understand the problem of scarcity better, by showing what can be produced with given resources and technology. The production possibility curve can be defined as a curve which shows the maximum combination of output that the economy can produce using all the available resources. Technology is the knowledge of how to produce goods and services.

A PPC tells us that to increase the production of one item, we have to forgo the production of some units of the other item. As resources are scarce, producers deciding to produce a certain good have to sacrifice the next best alternative good that could have been produced with the same resources. The value of the good given up is the opportunity cost. Opportunity costs are a result of scarcity.

There is always an opportunity cost when production choices are determined. Since the slope of the PPC shows how much of one good has to be sacrificed in order to produce another good, we can say that the curve explains the opportunity cost. If we concentrate on producing more and more of a particular

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Video 1.2.2:Economic Systems

good, the opportunity cost keeps on increasing. As a result, the PPC is concave to the origin.

Let us look at an example of the production possibility curve. Consider the production of two goods, say rice and cloth. Figure 1.1 shows different combinations of the two goods that can be produced. From the figure, we can see that production possibility C, with the resources available, we can produce two tons of rice and 12,000 meters of cloth. However, if we want to increase the production of rice to three tons, resources have to be diverted to the production of rice from the production of cloth. As a result, the production of cloth will drop to 9000 meters. In fact, if we want to produce 5 tons of rice, all our resources will have to be utilized for this, which means that we will not be able to produce any cloth at all (production possibility F).

Thus to increase the production of one item, we have to forgo the production of some units of the other item. Looking at the

figure 1.1, we can see that to increase rice production by one ton (from two tons to three tons), we have to forgo the production of 3000 mete rs o f cloth. In this case, the opportunity cost of the additional ton of rice is the value of the 3000 meters

of cloth forgone. An increase in the production or consumption of one good can be achieved only through the opportunity cost of the other good.

From the figure, we can see that increasing the production of rice from one ton to two tons causes a fall of 2000 meters in cloth production; and moving from two tons to three tons of rice production results in a 3000 meter drop in cloth production. So the opportunity cost of the second additional ton of rice is greater than the the opportunity cost of the first additional ton.

The PPC does not give the desirable point of production; it only indicates the possible combinations of the two goods that can be produced with the available resources. In other words, the PPC only helps us find out the combinations of outputs that can be produced with the available resources in an economy. All the points on the curve represent points at which

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Video 1.2.3: Production Possibil-ity Frontier with constant marginal

opportunity cost

Keynote 1.2.1:Production Possibility Curve

the economy operates at its full productive capacity, that is, all the factors of production are fully employed. However, in any economy, actual production may fall short of the capability. In such a situation, we obtain a point inside the curve, which indicates that resources are not completely utilized, i.e., there is unemployment in the economy.

The PPC illustrates the notion of scarcity by showing that, given the available resources and technology, production possibilities are limited; and at a given level of output of one good, once the maximum production possibility of the other good is reached, any increase in the production of the second good can come about only with a reduction of output of the first.

In the long run, given increases in the availability of resources and improvements in technology, the PPC can shift outward. This outward shift of the curve represents growth of the economy.

The three main sources of economic growth are:

Increase in the quantities of economic resources available.

Improvement in the quality of resources.

Advances in technology.

Technological developments enable higher productivity even with other factors of production remaining constant.

References

Scarcity

Opportunity Cost

Market Economy

Command Economy

Mixed Economy

Production Possibility Curve

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REVIEW 1.2.3

Check Answer

Question 1 of 8Opportunity costs are a result of

A. Scarcity

B. Overproduction

C. Technology obsolescence

D. Abundance of resources

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REVIEW 1.2.2

Check Answer

Question 1 of 4Which type of economy gives rise to the most efficient allocation of resources and capital in the standard mi-croeconomics framework?

A. Free market economy

B. Command economy

C. Mixed economy

D. Marxist economy

SECTION 3

Case Study: Switzerland, Cuba and India: The Troika of Economic Problems in Three Economies

All the economies of the world face the problem of scarcity of resources, which limits the production activities. Scarcity of resources makes an economy face trade-offs as producing more of one commodity means producing less of another commodity. Such trade-offs compel an economy to answer the three fundamental questions: What goods will be produced? How will the goods be produced? And for whom will the goods be produced? Economic Systems (Market, Command and Mixed) are the ways through which c o u n t r i e s a d d r e s s t h e s e t h r e e fundamental posers. Each type of economic system has its own way of deciding what commodities are to be produced, how and for whom.

Switzerland comes closest to the idea of market economy or capitalism. Private entrepreneurship forms the basis of the

Swiss economic policy. By the year 2000, most of the government enterprises w e r e p r i v a t i s e d i n Switzerland. Friedrich A. H a y e k , t h e A u s t r i a n economist, opined, Private

property is the most important guarantee of freedom.1 Property rights are important for the proper functioning of an economy. People in Switzerland are guaranteed

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Switzerland A Market Economy

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published sources.

private property rights, and they do not fear unjust dispossession. Switzerland has one of the best property rights regimes. It was ranked 8th out of 115 countries with a score of 8.2 in the 2009 International Property Rights Index (IPRI) .

Switzerland is an international banking centre with many Multinational Corporations (MNCs). It is one of the worlds freest economies. Switzerland was ranked 9th (Table 1.3.1) with a score of 79.4 in the 2009 Index of Economic Freedom

Most of the countries figuring in the index, Hong Kong, Singapore, UK, US, Finland, Ireland, Denmark, Netherlands and Switzerland, are free market economies and these economies also have higher per capita income (Table 1.3.2). According to UNDPs 2008 statistical

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Table 1.3.1: Index of Economic Freedom (2009): Top 10 countriesTable 1.3.1: Index of Economic Freedom (2009): Top 10 countriesTable 1.3.1: Index of Economic Freedom (2009): Top 10 countries

Rank Country Score

1 Hong kong 90.0

2 Singapore 87.10

3 Australia 82.6

4 Ireland 82.20

5 New zealand 82.0

6 US 80.70

7 Canada 80.50

8 Denmark 80.00

9 Switzerland 79.40

10 UK 79.0

12 Netherlands 77

17 Finland 74.5

Compiled by the author from: 2009 index of economic freedom Ranking the Countries, http://www.heritage.org/Index/ Ranking.aspxCompiled by the author from: 2009 index of economic freedom Ranking the Countries, http://www.heritage.org/Index/ Ranking.aspxCompiled by the author from: 2009 index of economic freedom Ranking the Countries, http://www.heritage.org/Index/ Ranking.aspx

Table 1.3.2: Nations with high Per Capita Income, World Bank (revised in 2008)



Rank Country Per capita Income (PPP* International$)

1 Liechtenstein 63590

4 Kuwait 49970

5 Norway 53320

6 Brunei Darussalam 49900

9 Singapore 48520

10 US 45850

12 Hong kong, China 44050

13 Switzerland 43870

17 Netherlands 39310

19 Ireland 37090

24 Denmark 36300

25 Finland 34550

31 UK 33800

* Purchasing Power Parity. The most common way of presenting the per capita income data is PPP figures.Compiled by the author from: Gross national income per capita 2007, Atlas method and PPP, http:// siteresources.worldbank.org/DATASTATISTICS/Resources/GNIPC.pdf, October 17th 2008



update, Switzerlands GDP per capita for a population of 7.5 million people is $37,3962 . Switzerland has also some of the highest wages in the world. Thus, a high standard of living prevails in the country. The market economy of Switzerland has earned it a Human Development Index (HDI) of 0.9555, ranked 10th out of 179 countries3.

In market economies, the means of production are owned by private individuals and most cost-efficient techniques of production are used. Holderbank, Switzerlands largest cement company, attributes its success to the best production technology and low production costs. Switzerlands market economy is based on international trade and banking. Swiss banks are known for very high standards of banking and financial services. The Swiss are the leaders in private banking. In 2003, it was reported that Switzerland with its 400 banks manage ... one-third of the worlds wealth that resides outside its country of origin.4 The Swiss banks are not subjected to any legal scrutiny. That is why the money (legal/illegal) from the entire world is deposited in Swiss banks. In September 2008, the UBS of Switzerland revealed to the US that it held 47,000 secret accounts for Americans.5 Capitalism results in generation of wealth the Swiss banking business is an attestation to this fact.

The Swiss are also known for their world-class watches, pharmaceuticals, electronics, chemicals, metals, precision instruments, chocolates, cheese and also for their ground breaking research and advances in organic agriculture and poultry production. Chemicals and engineering products are the biggest exports of Switzerland. Watches occupy third

place in the countrys exports. About 95% of Switzerlands watches are exported and it stands as the world largest watch exporter in terms of value. In 2006, Swiss watch exports were valued at 13.7 billion francs6. The average export price of a Chinese watch in 2006 was $1, in Hong Kong it was $8, while Switzerlands export price of a watch was on an average $410.7

Switzerland has extremely well-developed infrastructure for scientific research. The Research Institute of Organic Agriculture is the worlds leading information and documentation centre for organic agriculture. Swiss companies spend a lot of money on Research and Development due to which they come up with very innovative products. Swatch, the famous Swiss watch company has always flirted with technology. Besides manufacturing watches, Swatch is into manufacturing microprocessors, smartcard technology, portable telephones, and other future-oriented designs, such as wristwatches that double as telephones, credit cards, even concert tickets.8

The innovation in the field of technology in Switzerland, along with other factors like first-rate infrastructure and efficient markets, has boosted Switzerlands global competitiveness, and it has been featuring among the top ten economies in the Global Competitive Index (GCI) for many years (Table 1.3.3). Switzerland was ranked as the second most competitive country in the global economy for the years 2007 and 2008. The other capitalist countries like UK, US, Finland, Denmark, Netherlands, Singapore and Hong Kong have also been featuring in top ten countries of the GCI index.

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Trade has been the key to Switzerlands prosperity and growth. It has very liberal trade and investment policies, with minimum trade barriers (Table 1.3.4). In Global Enabling Trade Index released by World Economic Forum for the very first time in 2008, Switzerland was ranked 9th among 118 countries signifying its business-friendly environment and openness to international trade and investment. Exports generate lot of income and bost the economic growth. The Swiss economy

earns roughly half of its corporate earnings from the export industry, and 62% of Swiss exports are destined for the EU market.9 Government has a very limited role to play in Switzerland. The new agricultural policy of Switzerland, which came into effect from January 1st 1999 began eliminating detailed market regulations and reducing direct government intervention in setting up of market prices 10. Most of the Swiss

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Table 1.3.3:Global Competitiveness Index: 20002008










Rank 2000 2001* 2002 2003 2004 2005 2006 2007 2008

1 US Finland US Finland Finland Finland US US US

2 Singapore US Finland US US US UK Switzerland Switzerland

3 Netherlands Canada Taiwan Sweden Sweden Sweden Denmark Denmark Denmark

4 Ireland Singapore Singapore Denmark Taiwan Denmark Switzerland Sweden Sweden

5 Finland Australia Sweden Taiwan Denmark Taiwan Japan Germany Singapore

6 Canada Norway Switzerland Singapore Norway Singapore Finland Finland Finland

7 Hong Kong SAR Taiwan Australia Switzerland Singapore Iceland Germany Singapore Germany

8 UK Netherlands Canada Iceland Switzerland Switzerland Singapore Japan Netherlands9 Switzerland Sweden Norway Norway Japan Norway Sweden UK Japan

10 Taiwan New Zealand Denmark Australia Iceland AustraliaHong Kong SAR Netherlands Canada

* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008* Switzerland for the year 2001 ranked 15thCompiled by the author from Global Competitiveness Reports 20002008

government activities are confined to provision of public services like defence, railways, infrastructure and post office. The government policy aims at maintaining macro-economic stability in the country.

Corruption is less in market economies than in command and mixed economies. Even though the US financial crisis was alleged to be a result of corruption and greed, most of the

market economies are characterized by low levels of corruption. In a market economy, the scope for corruption is pre- empted to a great extent. Switzerland was ranked 5th out

of 180 countries in Transparency International Corruption Perceptions Index 2008 (Table 1.3.5). In contrast, command economy of Cuba was ranked 65th and the mixed economy of India was ranked 85th, which shows a very high level of corruption in these economies.

The biggest drawback of Switzerland is that it is characterized by inequality of income and wealth. A study by the World Institute for Development Economics Research in 2006 using

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Table 1.3.4: Transparency International Corruption Perceptions Index* 2008



Country Rank Country/ Territory CPI Score 20081 Denmark 9.31 Sweden 9.31 New Zealand 9.34 Singapore 9.25 Finland 9.05 Switzerland 9.07 Iceland 8.97 Netherlands 8.99 Australia 8.79 Canada 8.7

65 Cuba 4.385 India 3.4

* A country or territorys CPI score indicates the degree of public sector corruption as perceived by business people and country analysts, and ranges between 10 (highly clean) and 0 (highly corrupt)



Source: Transparency International Corruption Perceptions Index 2008, http://webcasts.acc.com/handouts/ TI_CP_Index_2008.pdf, pages 4 and 5Source: Transparency International Corruption Perceptions Index 2008, http://webcasts.acc.com/handouts/ TI_CP_Index_2008.pdf, pages 4 and 5Source: Transparency International Corruption Perceptions Index 2008, http://webcasts.acc.com/handouts/ TI_CP_Index_2008.pdf, pages 4 and 5

Source: 2008 World Trade Indicators published by the World Bank, www.economist.com

Keynote 1.3.1: Trade Barriers-2008

the statistics for the year 2000 came up with the data on wealth distribution for the whole world. According to the study, Switzerland had the highest concentration of wealth in the top 10% of the adult population (Table 1.3.6). Other capitalist countries like US, Denmark, France, UK, Germany and Finland also have concentration of wealth in few hands.

According a World Resources Institute report, Switzerlands Gini coefficient is 0.33. The percentage of total income earned by the richest 20% of the population in Switzerland is 40.3% and the percentage of total income earned by the poorest 20% of the population is 6.9%11.

Cuba Command Economy

There is the Cuban joke that in the socialist paradise, there are only three minor economic problems left to solve: breakfast, lunch and dinner.12

Cuba, Iran, Libya and North Korea are some of the countries where command economy still exists. Around 90% of the Cuban economy with a population of 11.4 million people is controlled by the state. The government controls all means of production and determines prices for most of the goods in the economy. It interferes heavily in the day-to-day economic lives of the Cuban people. Private entrepreneurship is thoroughly discouraged in Cuba. Laws governing private property are very complex in Cuba. Even though the constitution of Cuba allows Cubans to hold private property, they cannot buy or sell property. This shows that Cuba does not have proper property rights in place and that could be one of the reasons why it did not feature in 2009 IPRI. The government controls all the spheres of life in Cuba. The governmental spending for the year 2008 equalled 72.6% of GDP13 .

Cuba, once a colony of US, gained its independence through the Cuban Revolution in 1959. Fidel Castro (Fidel) overthrew Fulgencio Batistas US-backed army and established his empire. On account of the ongoing friction between Cuba and US, in 1960, Cuba nationalised three US oil refineries namely, Texaco (on June 29th 1960), Esso (on July 1st1960) and Shell (on July 1st1960). Thus, on July 3rd 1960, US suspended trading sugar

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Table 1.3.5: Percentage of Wealth Held by the Top 10% of the Adult Population in Various Countries

Table 1.3.5: Percentage of Wealth Held by the Top 10% of the Adult Population in Various Countries

Country Wealth Owned by the Top 10%Switzerland 71.3%US 69.8%Denmark 65.0%France 61.0%Sweden 58.6%UK 56.0%Canada 53.0%Norway 50.5%Germany 44.4%Finland 42.3%Source: Domhoff William G., Wealth, Income, and Power, http://sociology.ucsc.edu/whorulesamerica/power/wealth.html, September 2005 (Updated on December 2006)

Source: Domhoff William G., Wealth, Income, and Power, http://sociology.ucsc.edu/whorulesamerica/power/wealth.html, September 2005 (Updated on December 2006)

with Cuba, by passing the Sugar Act in the Congress. Nearly 80% of the Cuban sugar exports to US were cut off. Cuba retaliated by nationalising all US businesses and commercial property on July 5th 1960. The following day, the then US President Dwight David Eisenhower cancelled the 700,000 tonnes of sugar remaining in Cubas quota for 1960. USSR decided to buy the 700,000 tonnes of sugar cut by US, and thus the sugar-for-oil exchange between Cuba and USSR was born. It was estimated at that time that Cuba was doing 85% of its trade with USSR.

In September 1960, Cuba nationalized all US banks. On October 13th 1960, Fidel nationalized local firms, which included large agricultural estates, sugar refineries, banks, mining firms, large industries and privately owned urban property. Following this, US imposed a trade and economic embargo on Cuba excluding food and medicine on October 19th 1960.

Cuba defended itself against the US invasion at Bay of Pigs on April 17th 1961 and defeated the US army after 3 days of fighting government 14. Fidel established a centrally planned system and nationalised all means of production.

Even after the imposition of US embargo, Cuban agricultural production remained high, with USSR buying sugar from it at more than the market price. But in early 1990s, as the USSR collapsed, so did Cuban economy and its agricultural production. Instead of choosing to open up its markets and agricultural production to the forces of free markets, Cuban government continued to control agricultural production and marketing. As a result of the socialist management, the sugar

production started falling, and hence the once prosperous sugar industry lost all its glory. It was opined, Inefficient planting and cultivation methods, poor management, shortages of spare parts, and poor transportation infrastructure combined to deter the recovery of the sector.15 Sugar industry fell from 8.1 million metric tonnes in 1989 to 3.5 million metric tonnes in 1995. In June 2002, Cuba announced it would have to close half of the countrys 156 decrepit sugar mills16.

Shortages are common in Cuba, due to poorly run state factories and firms. Command economies result in the formation of shadow or black markets. Cubas black market has been flourishing because when the government controls the distribution of goods and services, producers start selling things illegally. Cubans have been increasingly buying the needed food and clothing from the black markets at very high prices. The black markets bypass all the government restrictions. Moreover, Cubans get to buy the very essential items which are not available at the government ration shops.

In Cuba, government exercises control over employment issues. As per the Government statistics, about 75% of the labour force is employed by the state. The actual figure is however, closer to 93%17. A meagre 3% of the total workforce (4.87 million) is allowed to be self-employed. If a foreign company intends to hire workers, it can be done only through the recognised state agencies. Workers are paid only a fraction of the amount that is charged to foreign companies.

Cuba has a very hostile business and investment environment characterised by dense regulations and impenetrable communist bureaucracy. Trade is non-transparent and the

22

government controls imports and exports. The non-tariff barriers to trade are very restrictive. All these put together are deterring foreign investment in Cuba. Most of the foreign investment in Cuba, takes place through joint ventures with state companies, which have majority of the ownership. A paper titled The Legal and Administrative Framework for Foreign Trade and Investment by European Companies in Cuba, given to the Cuban government by the European Union in July 2002 contained the problems that were encountered in the operations of joint ventures in Cuba. The paper pointed out the difficulty in obtaining work permits for foreign employees. It also complained that EU joint venture partners had no say in hiring employees and often they were forced by the Cuban government to hire employees who were professionally not suitable and securing finance was also very difficult18. The Cuban government did not respond. Cuba has been witnessing fall in foreign investment due to such difficult investment environment Of the 540 joint ventures formed since the Cuban Government issued the first legislation on foreign investment in 1982 ... 287 remained at the close of 2005 ... Foreign direct investment flows decreased from $448 million in 2000 to $39 million in 2001 and were at zero in 2002.19

The citizens of Cuba are denied the freedom of expression the freedom of speech and press. Cuban jails contain prisoners of conscience, who have been detained just because of their beliefs. Cubans are denied the right to change their government. Assembly of more than three persons is punishable under the law in Cuba. Access to internet and outside media is heavily controlled. It is illegal in Cuba to own a TV satellite dish. The 2009 Index of Economic Freedom,

ranked Cuba 177 out of 179 countries. The two countries ranked after it are Zimbabwe and North Korea; both of them are command economies.

Command economies are characterized by equitable distribution of income and wealth. Cuba under Fidel in 1960s witnessed more equitable wages. The income gap between the farmers and the urban workers decreased as wages were controlled by the government. Fidelss agenda, employment for all, brought all the classes on the same platform. All Cuban children go to school and even a remote village has a school in Cuba. It has a literacy rate of 99.8%. Cubans also enjoy a good healthcare, and they have achieved many breakthroughs in the field of biotechnology. And that is why HDI ranked Cuba 48th out of 179 countries (Table 1.3.7). By 1986, Cubas Gini coefficient of 0.25 was among the lowest in the world. Cuba has set an example of an egalitarian economy.

But in 1990s, following the collapse of USSR, Cuban economy was in a deep crisis. To alleviate the crisis, Cuba introduced

some market reforms, like legalisation of dollar, allowing foreign investment, opening of the country for tourism, legalisation of some private enterprises and self-employment for 150 occupations. Following the legalisation of dollar, the Cuban Peso became worthless and inequalities between the Cubans rose. The Cubans who had access to dollars earned higher incomes. Jobs like driving taxis and working at restaurants which earned salaries/tips in dollars from foreign businesses and tourists became highly desirable. Cubas Gini coefficient of 0.40 in 1999 turned up similar to US. The Cuban government

23

tightly controlled the small private sector that evolved during 1990s.

Fidel in his Cuba established Soviet-style rationing of housing, goods and food20. Cubas rationing system started in 1962,which severely limited the quantity and choice of Cuban consumers. People of Cuba for many decades have been surviving on ration books that provide limited amount of essential products like rice and beans. Cuban parents can buy subsidised milk powder (which comes to one glass a day) for children less than 7 years of age. Once a child turns 8 years old, it is not available. Fresh fruits and meat are scarce and beyond the reach of ordinary Cubans. the ration, which the

government provides, lasts only 10-15 days and many Cuban women, in a desperate attempt to feed their families, have turned to prostitution so that they get enough money to buy

provisions for the remaining half of the month in the expensive Cuban black markets. In October 2008, it was reported that the Cuban government was putting a limit on how much fruits and vegetables Cuban people can buy in farmers market. Lettuce was limited to two pounds per person21.

Command economies have a very low unemployment rate compared to market and mixed economies. Cuban government has been committed to provide employment to each of its citizen. Cuba also has a moderate level of inflation (Table 1.3.8).

There are very few markets in Cuba and many of the farmers are prohibited from selling their extra produce in the markets. In February 2008, Fidel Castros nearly five decades of rule came to an end when his brother Raul Castro (Raul) was appointed the President of Cuba. President Raul in 2008 announced that farmers will be allowed to sell their extra produce in local markets and also, there will be large scale distribution of land to private farmers. However, farmers still face rules about what and how much they can plant, and risk losing their land if they fail to meet government production quotas. They are also required by law to sell any surplus to farmers markets.22

With the coming of Raul to power, some are hoping that Cuba may open up and witness some changes in the economic realm. But many analysts believe Cubas transition to a market economy is not possible as long as Fidel is alive. However, to make a start in loosening the Cuban economy, Raul in February 2008 made some announcements (Table 1.3.9). Countries like Canada, Spain, China and Russia are emerging as prominent foreign investors in Cuba. Many analysts agree with the notion

24

Table 1.3.6:Cubas Human Development Index 2006





HDI value 2006

Life expectancy

at birth (years)2006

Adult literacy rate (ages 15

and above (%))2006

Combined primary,

secondary and tertiary gross

enrolment ratio (%) 2006

GDP per

capita (PPP in $) 2006

0.855 77.9 99.8 94.8 6876

Source: 2008 statisical update CubaSource: 2008 statisical update CubaSource: 2008 statisical update CubaSource: 2008 statisical update CubaSource: 2008 statisical update Cuba

that Cuba will slowly make a transition to a conventional market economy.

Jawaharlal Nehru, Indias first Prime Minister introduced the concept of mixed economy in India. He intended to incorporate the best features of market and command economy in India. Till 1990s, the government occupied a very important role in the economy and private sector was severely regulated and thoroughly discouraged by excessive bureaucratic controls. State was actively involved in providing for healthcare, education, defence and development of infrastructure in the country. All the other major industries like mining, banking and

insurance, communications, transportation, manufacturing and construction were also under government control.

In 1990s, there was a paradigm shift in the Indian economic policy. Private sector was invited to take on sectors like education, communications, civil aviation, healthcare, banking and insurance. As a result, government and private players were present in most of the sectors simultaneously. In the civil aviation sector, there have been governments Indian Airlines and Air India, co-existing with private airlines like East West

Airlines, Air Deccan, Go Air, Jet Airways, Kingfisher Airlines, etc. Private sectors also started having a firm grip on educational and healthcare sectors. Indias financial sectors have (as on 2009), 28 state-owned banks controlling about 71% of commercial banking, 29 private banks, and 31 foreign banks23. In the recent times, development of infrastructure has been opened to private sectors also. There is private property in India, but it needs improvement in the area of protection of

25

Table 1.3.7: Inflation and Unemployment Figures of Switzerland, Cuba and India-2008



CountryInflation (CPI)

(%)Unemployment Rate

(%)

Switzerland 0.9 2.5

Cuba 3.6 1.8

India 6.4 7.2

Table 1.3.8: Announcements made by Raul Castro (february 2008)

Expanding access to public land for private farmers Permitting some Cubans to own their homes Increasing wages and retirement pensions Licensing private taxis to operate Limited deregulation of the construction industry Expanding access to certain previously restricted consumer

goods (like cell phones, computers, microwaves, toasters, DVD players, motorcycles, air conditioners, electric ovens, agricultural supplies and tools)

Launching a new 24-hr television station to include mostly foreign produced content.

Compiled by the author from Background Note: Cuba,http://www.state.gov/r/pa/ei/bgn/2886htm, August 2008

property rights. India was ranked 46th in 2009 IPRI with a score of 5.6.

The private sectors role in the economy has raised overall production and efficiency. Telecommunication sector, after the entry of private players became very efficient and cost-effective. The advent of private sector in civil aviation increased the comfort in travelling and the airfares got slashed due to the healthy competition between the air

carriers. Private sector in India has set very high standards in the education, healthcare, banking and tourism segments.

Since private sectors aim is maximisation of profit, they venture only into those avenues which will increase their revenues. Therefore, the government provides services to rural and low-income people who are largely untouched by the private sector. Indian government has retained the ownership over the strategic sectors like defence and artillery, maintenance of law and order and railways. Thus, in India, government controls the sectors which are important for its growth and stability. The total government expenditure in India is moderate, equalling 27.2% of GDP24.

India has a huge consumer base. It is the second largest consumer market in terms of population. While production of goods and services are carried by both private individuals and government, the decision about consumption of goods and service rests entirely on the consumers. Indian consumers decide what to buy out of all the choices given.

And incomes of the consumers and prices of goods and services also play an important role in determining consumption. In the recent years, Indian consumers have become environment friendly and eighty-eight percent of Indian consumers are prepared to pay more for goods that are environmental friendly25. Prices in Indian markets are determined by the interaction of demand and supply forces of goods and services. Even though Indian government does not tell people what to buy or sell, it is actively involved in regulating the market.

Corruption is very highly prevalent in India (Table 1.3.6). In India, the difference between the public and private sector is clearly visible. Public sector undertakings have become the property of a few politicians. Despite being run by the government, Indian economy is characterised by a great disparity between the rich and the poor. Indias Gini coefficient is 0.38 where 46.1% of the total income is earned by the richest 20% of the population, and just 8.1% of the income is earned by the poorest 20% of the population26.

Compared to market economies, mixed economies have a low standard of living measured in terms of HDI and per capita GDP. Indias HDI value27 is 0.609 with a rank of 132nd and its GDP per capita28 is $2,489. India is ranked 123rd in the 2009 Index of Economic Freedom. Out of all the three economies, Switzerland is the freest economy followed by India and Cuba (Table 1.3.9)

Most of the market economies of the world like Switzerland, US, Singapore, Hong Kong have relatively open market systems in their respective countries. Neither market

26

India Mixed Economy

economy nor command economy exists in pure form. The basic difference between the two is that while in a market economy buyers and sellers decide the three basic questions of the economy, in a command economy the government pulls the string. In some degree or other, all the economies of the world are mixed economies, with market features and government controls existing simultaneously. The question that remains to be answered is how much mixed an economy should be?

27

TABLE 1.3.9:2009 INDEX OF ECONOMIC FREEDOM OF CUBA, INDIA AND SWITZERLAND A COMPARATIVE ANALYSIS

COUNTRY NAMEOVERALL SCORE

BUSINESS FREEDOMTRADE FREEDOMFISCAL FREEDOM

GOVERNMENT SIZEMONETARY FREEDOM

INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM





INVESTMENT FREEDOM

Country Name

Overall Score

Business freedom

Trade freedom

Fiscal freedom

Government Size

Monetary freedom

Investment Freedom

Financial freedom

Property rights

Freedom from

corruption

Labour freedom

Cuba 27.9 10 64.4 45.9 - 67 10 10 10 42 20

India 54.4 54.4 51 73.8 77.8 69.3 30 40 50 35 62.3

Switzerland 79.4 82.9 85.4 67.5 65.3 83.9 70 80 90 90 79.2

Footnotes

1.Dedigama C. Anne, INTERNATIONAL PROPERTY R I G H T S I N D E X ( I P R I ) 2 0 0 9 R e p o r t , h t t p : / / www.internationalpropertyrightsindex.org./atr_Final1.pdf, page 11

2.2008 Statistical Update Switzerland, http://hdrstats.un dp.org/2008/countries/country_fact_sheets/cty_fs_CHE.html, December 18th 2008

3.2008 Statistical Update Switzerland, op.cit

4.Beng Kim Phar, Capitalisms Mistress: Private Banking, http://www.globalpolicy.org/socecon /crisis/2003/0625 mis-tress .htm, June 25th 2003.

5.A i y a r S h a n k k a r , M i n t i n g p o l i t i c a l c a p i t a l , http://in.elections.yahoo.com/articles.html?feed=http://in.news.yahoo.com/ 248/20090422/1585/ tn l - mint ing- political-capital_1.html, April 22nd 2009.

6.The Swiss watch industry, http://www.swiss world.org /en/ sw i t ze r l and / sw i ss_ spec ia l s / sw i ss _wa tches /the_swiss_watch_industry/

7.Ibid.

8. T h e S w a t c h G r o u p S A , h t t p : / / w w w. f u n d i n g universe.com/company - histories/ The-Swatch-Group-SA-Company- History.html

9. Background Note: Switzerland, http://www.state.gov/ r/pa/ei/b gn/3431.htm, January 2009.

10. S w i t z e r l a n d , h t t p : / / w w w. u s t r . g o v / a s s e t s / D o c u m e n t _ L i b r a r y / R e p o r t s _ P u b l i c a t i o n s / 2 0 0 3 / 2003_NTE_Report/ asset_ upload_file346_6225.pdf, page 354

11.Economics, Business, and the Environment, http://earth trends.w ri.org/te xt/economics - business/country-profile- 174.html

12.Roberts M. James, Cubas Phony Transition: Fidel Re-signs, Raul Reigns, http://www.heritage.org/Research/ LatinAmerica/wm1820.cfm, February19th 2008.

13.Cuba, http://www.heritage.org/Index/Country/Cuba

14.JohnsonStephen,TimeForConsensusOnCuba,http://www.heritage.org/research/latinamerica/bg1579.cfm,August 30th 2002.

15.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit

16. Ibid.

17.Background Note: Cuba, http:/ /www.state.gov /r/pa/ei/bgn/2886.htm, August 2008

18.Ibid.

19.Ibid

20.Cubas Phony Transition: Fidel Resigns, Raul Reigns, op.cit

28

21.Garcia Anne-Marie, Cuba Begins Rationing Food, http://www.infowars.com/cuba-begins-rationing-food/, Octo-ber 12th 2008.

22. C u b a g i v i n g l a n d t o p r i v a t e f a r m e r s , h t t p : / / e c o n o m i c t i m e s . i n d i a t i m e s . com/articleshow/msid-2929895,prtpage-1.cms, April 6th 2008.

23.India, http://www.heritage.org/Index/Country/India, 2009.

24.Ibid.

25.Indian consumers favour eco-friendly products: study, http://www.thaindian.com/ne wspo rtal/business/indian-

26.c o n s u m e r s - f a v o u r - e c o - f r i e n d l y - p r o d u c t s - s t udy_100129834.htmlCountry Profile India, http://earth t r e n d s . w r i . o r g / t e x t / e c o n o m i c s - business/country-profile-85.html

27.2008 Statistical Update India, http://hdrstats.u ndp.org /2008/countries/ country_fact_sheets/cty_fs_IND.html, De-cember 18th 2008

28.Ibid

29

Theory of Demand and Supply

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2

SECTION 1

Introduction to Demand & Supply

Multinational companies such as McDonalds and Kelloggs entered the Indian market in mid 1990s. Initially, McDonalds offered products which were not customized to the Indian tastes. The company seemed to have overestimated the demand for its products and hence almost all its operations ran into losses. McDonalds was able to capture a reasonable market share in the Indian fast-food segment when the company made some changes in its menu during the late 1990s, which were more su i ted to the tas tes and

preferences of the Indian customers. Similarly, Kelloggs planned to replace heavier Ind ian b reak fas t w i th an alternative l ike cornflakes. However, the company was not able to estimate the right demand fo r i t s p roduc ts . Kelloggs was unsuccessful due to wrong demand forecasting and premium pricing of its products.

In the case of both McDonalds and Kelloggs, there were cheaper alternatives available. This was one of the reasons

31

http://www.truckertotrucker.com/wp-content/uploads/2011/03/gas-1.png

why the Indian customers did not readily switch to the products offered by the multinationals.

The above examples suggest the significance of analyzing the forces of demand and supply of any goods or service. The objective of a firm is to maximize its profits. The demand for its product(s) plays a major role to achieve this objective. Those firms whose products have inadequate demand are not able to generate sufficient revenues, and hence, are forced to close down their operations. Therefore, demand analysis is very important for a firm to determine the price of a product and the quantities to be produced.

Firms market entry decision hinges crucially on profit. The demand for the goods is not the only factor that ensures firms profit, but the price of the input factors as well as the price of the output of the firm are also equally important. Therefore, supply analysis is also very important for a firm to optimally and efficiently produce the output so as to compete in the market.

This chapter will extensively discuss the theory of demand and supply. First segment of the chapter will discuss the basic concepts and laws associated with demand and supply, key determinants of demand and supply. The second section will throw light on market equilibrium and the government intervention in the market. Measurement of elasticities of demand and supply will be covered in the third section of this chapter.

32

SECTION 2

Theory of Demand

In economic theory, demand and supply has a great significance since the wants are unlimited and resources are limited. In economics the demand is defined as de-sire backed by ability and willingness to buy a product or service at alternative prices other things being constant.

Law of Demand

The law of demand explains the relation-ship between the price and the quantity de-manded in a particular period. The law re-fers to the direction in which the quantity de-manded changes with change in price. The law of demand states that other things be-ing constant (ceteris paribus) the quantity demanded increases with a fall in price and quantity demanded decreases with a rise in price.

The quantity demanded of the product not only depends on the price of the product alone, but also a host of other factors which determine the quantity demanded of the product, such as the taste and prefer-ences of the consumer, seasonal changes, income of the consumer, price of alterna-tive product and services, etc.

Demand Schedule

Listing of the various quantities that the con-sumer is willing to buy at different prices in a given period of time in a tabular form is called the demand schedule. The demand schedule is usually represented in a tabular form where it depicts the alternative prices of the product and the corresponding quan-tities demanded at a given period of time (Table 2.2.1).

33

Video 2.2.1:Theory of Demand

Demand Curve

When we represent the demand schedule in the form of a graph we get the demand curve. In the figure below, we have plotted the data given in the demand schedule. Here, it is a typi-cal downward-sloping demand curve. The following diagram shows that at very low price, the consumers want to purchase higher quantities of chocolates, keeping other factors un-changed and vice versa.

Demand Function

Demand function: A function that depicts the relationship be-tween how much of a good will be demanded at alternative prices of that good and alternative values of other non price variables affecting demand. The demand function for the good X can be written mathematically as:

Qx= f( Px , Py, Y, e )

Where,

Qx: quantity demanded of good X

Px: own price of good X

Py: prices of the related goods Y

Y: income of the consumer

e: Other non-price factors that influence demand.

The nature of the demand function differs from goods to goods. However, the simplest form of demand function is the linear demand function. The linear demand function is a func-tion where the demand of a good is a linear function of its own price and other variables influencing demand.

Factors determining demand

There are wide array of factors which influence demand. Price is considered to be the most important factor that determines demand. There are also many no-price factors which influence demand. Some of the non-price factors which influence de-mand are discussed hereunder:

Income of the Consumer:

Other things being constant, if the income of the consumer in-creases the demand for the product increases and vice versa.

34

Table 2.2.1

DEMAND SCHEDULE FOR CHOCOLATESDEMAND SCHEDULE FOR CHOCOLATES

PRICE QUANTITY DEMANDED

10 20

12 18

14 16

16 14

18 12

20 10

Price of Substitutes

Other things being equal if the price of the product increases the demand for that product decreases and the demand for the substitute product increases and vice versa.

Changes in government Policy

The demand for a product may also depend upon government policies. For instance, if the government increases taxes on products, prices increase and hence the quantity demanded decreases in the short run. Government may also prohibit the consumption of a product or set limits on its consumption.

Tastes and Preferences of the consumer

The tastes and preferences of the consumer also affect the de-mand for a product. To an extent, prevailing fashion, advertis-ing and an overall increase in standard of living influence con-sumer tastes. For example, when multinational Quick Service Restaurant (QSR) chains like Pizza Hut and McDonalds en-tered India, they found that their products did not cater to the Indian tastes. These companies had to not only change their pricing, but they also had to alter their menu to make it more suitable to the tastes and preferences of Indian consumers.

Expectation Regarding Future Price Changes

If a consumer expects a fall in the price of a product in the near future, the present consumption of that product may come down. This, however, depends on the nature of the prod-uct. If the product is essential or perishable, the consumer can-not postpone the purchase of that product. Even if the price of

a staple food like rice (or wheat) was expected to fall, there is a limit to the consumers ability to postpone its consumption.

Special Influence

Demand may also be influenced by other factors like climate change, demographic changes, population migration and technological progress.

Change in quantity demanded vs Change in demand

There is a need to understand the difference between change in quantity demanded and change in demand.

Change in quantity demanded

The change in quantity demanded indicates the relationship between price and quantity demanded which is the move-ment along the demand curve, keeping other things being constant. Ceteris paribus, higher is the price, lower is the quantity demanded and vice versa. Change in quantity de-manded is also known as variations in demand (shown in the following Keynote 2.2.1)

Change in demand

The non-price factors will have an influence over the demand for the product. These factors may cause shift in the demand curve either rightward or leftward. Some of the non-price fac-tors are discussed below. A change in demand, whether an increase or a decrease, refers to the shift in the demand-curve, towards the right or towards the left, caused by a change in any of the non-price determinants of demand (shown in the Keynote 2.2.1).

35

Nature of Demand

The nature of demand differs from goods to goods. The sim-plest form of demand function is the linear demand function through which an attempt is made hereunder to demonstrate how the factors influence demand.

Linear demand function shows the linear functional relation be-tween the quantity demanded of good X (Qx) and own price of good X (Px), prices of the related goods(Py,), income (Y) and other non price factors (O) that determines demand. The linear demand function can be presented as follows:

The signs of depict how the changes in determinants

of demand will influence demand for the good X. As per the law

of demand,

goods are not Giffen goods. Giffen good violates the law of demand.

References

Demand Theory

Law of Demand

REVIEW 2.2.1

Check Answer

Question 1 of 4Which of the following is true about demand?

A. Existence of wants

B. Need without which one cant do without

C. Desire, not satisfiable by anything else

D. Desire backed by ability and willingness to pay

37

Keynote 2.2.2 Income vs. De-mand of a Product

SECTION 3

Case Study: Do Soaring Price and Mounting Demand in Indian Gold Market Speak of Paradox

Demand for gold is a widespread observable fact across the world. However, the major demand for gold comes from five countries, namely India, Italy, Turkey, US and China. Among these countr ies, which account for 55% of the total gold demand, Indias share alone comes to around 25%. Cultural and religious tradi t ions involving wearing of jewellery play a major role in influencing Indian gold demand. Around 75% of the world demand for gold is jewellery-based and the rest 25% is investment based. Speaking about Indias fondness for gold, Lord John Maynard Keynes is alleged to have remarked , I nd ia s go ld

consumption reflects the ruinous love of a barbaric relic.1

In India, there is a huge mismatch between demand for and supply of gold. Hutti Gold Mine Company located in Karnataka is the only company in India, which produces gold by mining and processing the gold ore. It produces around 3 tonnes of gold per year. Another source of supply of gold in India has been coming from recycled jewellery/scrap jewellery. In 2006, it was reported that, Over the past five years, Indians have recycled an average of 105 tonnes of gold per annum.2 To meet

38

This case study was written by Hepsi Swarna under the direction of Akshaya Kumar Jena, IBSCDC . It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was written from published sources.

the bulk of the demand, India imports gold. India imports around 700 tonnes of gold a year.3

In October 2008, demand for gold increased. While this increase in demand for gold was attributed to the falling gold price from $900 to $712 per oz.4, some were of the view that it is because of the festivity of Diwali5, which requires people to purchase gold ornaments without taking price situation. into account. However, the weakness of the latter argument was shown up by citing the instance of the same Diwali festival of 2007 when the price registered a rise and surged above $800 per oz. mark and the demand for gold jewellery decreased. The very high price is alleged to have dampened the demand for gold, especially in the jewellery sector. Experts, however, pointed to real estate and the Bombay Stock Exchange as bet ter investment havens for Indians in October 2007 to switch their funds to away from gold bullion. However, back in 2005, as the gold prices went up demand also went up, making the analysts comment that the demand curve for gold in India is inverted.6 The higher the gold price rises in rupee terms, the stronger becomes the conviction of Indians that gold is the best

means of preserving and enhancing ones wealth. This conviction started manifesting itself again towards the last quarter of 2008 when the US-originated worldwide recession drove investors to park their funds in the safe haven of gold, thus keeping the investment demand for gold high. But the jewellery demand for gold saw huge dip in India due to the price increase. Indias demand for gold is met through imports and recent gold import figures highlight the demand destruction that has taken place. Imports of gold are reported to have fallen by 83% in December 2008 and by 91% in January 2009.7 India is reported to have imported zero gold in February 2009; imports during March 2009 has also been zero. The

relationship between gold price and Indian gold demand seems to be negative during some years and positive in some other years (Exhibit I).

The price of gold and the quantity demanded of gold in India for the above time series when plotted against each other in a tabular form, give rise to a straightforward demand schedule (Exhibi t I I ) . The graphical translation of it gives rise to demand curve.

While the periods 19921993, 1996 1999 and2003 show up t h e n e g a t i v e r e l a t i o n s h i p

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Source:www.gold.org/assets/file/rs_achieve

Exhibit I

between price of gold and the quantity supplied of it, the periods 19911992, 19931996 and 20032005 reveal a positive relationship.

The apparent positive relationship between price of gold and its demand is often due to the presence of the non-price factors (Exhibit III). In 2004, it was reported that, Indians are enjoying a rapid acceleration in income growth, which is supporting discretionary spending on consumer goods, including gold.8 The demand for gold increased during that

time even in the face of rising gold price because as more and more workers moved from low income to middle and high-income groups, their demand for gold also increased. A World Gold Council study in 2006 conducted across six key gold markets, including India, revealed that, gold has become a more relevant and desirable product to a greater number of women9, thanks to increasing economic independence of women in developing countries. In order to disintegrate the various factors influencing the quantity demanded, the economists have employed the technique of showing the price factor alone and its influence on quantity demanded by means of a demand curve. The influence of non-price factors such as income on the quantity demanded is shown by a shift of the whole demand curve itself. Besides income, other non-price factors include prices of related goods, size of the population, consumer tastes and preferences, expectations about future conditions, etc.

In February 2009, it was reported that platinum was nearly half the price it was in 2008. When the gold prices were steeply climbing and the price of platinum was falling during the first 2

40

Exhibit III: Non-price Determinants of DemandExhibit III: Non-price Determinants of Demand

1 Income of the customer

2 Price of related good

3 Consumers taste and preference

4 Population

5 Expected future price of the good

Compiled by the authors from The Role of Gold in India,http://www.gold.org/assets/file/rs_archive/the_role_of_gold_in _india.pdf.September2006, page 2

Exhibit IIDemand Scheduled of Gold (1991-2005)

months of 2009, Indians started substituting platinum for gold due to near parity of prices between gold and platinum. Vijay Jain, chief executive of leading jewellery chain Orra, opines, there is a new-found love for platinum among Indian buyers because the precious metal has lost around 30% of its value in comparison to gold.10 He further says, A 10-gm platinum ring is now priced around INR 22,000 as against INR 35,000 a year-ago.11 The high gold price accompanied with declining platinum price made Indians dump gold and embrace platinum as reflected by the increase in the market share of platinum from previous 15%40% as on January 2009.12 The size of the population in India being so large, demand for gold in India also sums up to a huge quantity. Rising rate of population growth calls for increasing demand for gold. Tastes and preferences represent a variety of cultural, religious and historical influences. Indias demand for gold has its roots in cultural and religious traditions. In India, gold is seen as a symbol of status and it also plays a major role in a girls wedding. Festivals like Diwali and Akshaya Tritiya are regarded as auspicious occasions to buy gold. Thus, demand for gold is associated with cultural and religious beliefs in India. Another factor that affects the demand for a good is the expectations about future. The continued expectation about rising trend in gold prices has swayed the investors into purchasing more of gold even if its price is on the rise. In February 2009, as gold crossed INR 15,000 mark, investors increased their demand for gold, as they expected the gold prices to go up to INR 20,000. The uncertain economic conditions resulting from the global recession in 2008 has also made investors switch their funds from distressed financial

assets to ever- alluring gold. This increased investment demand for gold has sent the gold prices soaring. And the higher the gold price, the higher will be the investment demand for gold since it creates stronger expectations of continuing optimistic trend, especially when business scenario all around is pessimistic. But some analysts counter argue that the worlds demand for gold being no more money based but majorly jewellery based, high gold price will eventually lead to destruction of jewellery demand and overall gold demand.14

Seventy Five percent of the worlds demand for gold is for making jewellery while nowhere in the world the monetary system is based on gold.

The simultaneous exertion of various forces on the quantity demanded of gold often masks the lone influence of the price of gold. But a disaggregated careful analysis would reveal the actual relationship between price and quantity demanded of a good. Whether this relationship is positive or inverse depends upon the combined strength of the substitution effect and income effect of the price change of gold.

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Footnotes

1.Kannan R. and Dhal Sarat, Indias demand for gold: some issues for economic development and macroeconomic pol-icy, http://findarticles .com/p/articles/mi_m1TSD/is_1_7/ai_n28026379/, June 2008.

2.Dempster Natalie, The Role of Gold in India, http://www.go ld.org/ass ets/file/rs_ archive/the_role_of_gold_in_india.pdf, September 2006, page 6

3.India 200809 platinum consumption seen at 932 kg, http://in.reu ters .com/artic le/businessNews/idINIndia-34148820080620, June 20th 2008.

4.Gold Demand Trends Full year, http://www.gold.o rg/as sets/file/pub_archive/pdf/GDT_Q4_2008.pdf, February 2009, page 11

5.Diwali is an Indian festival, celebrated in the month of Octo-ber or November and buying gold is considered auspicious on that day.

6.Hamilton Adam, Global Gold Highs, http://www.zea lllc.com/2005/glogold.htm, October 14th 2005.

7.M e h r a C h a n d , I s i n v e s t i n g i n g o l d r i s k y ? , http://www.rediff.com/c ms/ print.jsp? docpath=//money/2009-/mar/ 16guest-is-investing-in- gold-risky.htm, March 16th 2009.

8.The Role of Gold in India, op.cit., page 5

9.The Role of Gold in India, op.cit., page 5

10. Indian buyers dump gold, embrace plat inum, http://www.commodity online. com/news/Indian-buyers-dump-gold-embrace- platinum-15342-3-1.html, February 19th 2009.

11.Ibid.

12.P la t inum-Gold pr ice d i f fe rent ia l a lmost zero , http://www.commodity online .com/news/Platinum-Gold-price-differential-almost -zero - 15558-3-1.html, February 27th 2009.

13.Is investing in gold risky?, op.cit.

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SECTION 4

Theory of Supply

In economics the word supply implies the various quantities of a commodity offered for sale by producers during a given period of time at various prices. Like demand, supply is also influenced by price as higher price positively impacts the sellers willingness to sell, and often, the ability to bring the goods and services to the market as well.

LAW OF SUPPLY:

The Law of Supply states that other things being equal (ceteris paribus), lower the price lesser the quantity supplied and vice versa. It indicates the positive relationship between price and quantity supplied. The supply curve will be upward sloping.

Supply schedule:

Listing of the various quantities that the seller is willing to supply at different prices in a given

period of time is called the supply schedule. The supply schedule is usually represented in a tabular form where it depicts the price of the product and the corresponding quantity supplied at a given period of time (Table 2.4.1).

Table 2.4.1: Supply Schedule of Chocolates Table 2.4.1: Supply Schedule of Chocolates Table 2.4.1: Supply Schedule of Chocolates

Situation Price (Rs per box)

Quantity Supplied (boxes)

A 50 22

B 40 15

C 30 9

D 20 4

E 10 0

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Video 2.4.1:Law of Supply

Figure 2.4.1: Demand Curve

When we represent the supply schedule in the form of a graph, we get the supply curve. In the figure below, we have plotted the data given in the table. Here, it is a typical upward-sloping supply curve. At very low prices, the chocolate manufacturers might want to use their factories for producing other types of related products. But as the price of chocolates increases, the manufacturers find it more profitable to shift to chocolates. Thus higher the price of chocolates, the greater the amount of chocolates supplied. The supply curve here is represented by a smooth upward-rising curve (Figure 2.4.1).

Supply Function

The supply function can be written as:

S = f(P, C, S, T, C, G, O)

S: Supply

P : Price of the products

C: Cost of production

S: Availability of substitutes

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