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INTRODUCTION TO MANAGERIAL ECONOMICS

Managerial economics is a discipline which deals with the application of economic theory tobusiness management. It deals with the use of economic concepts and principles of businessdecision making. Formerly it was known as Business Economics but the term has now been

discarded in favour of Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodologywhich are generally applied to seek solution to the practical problems of business. ManagerialEconomics is thus constituted of that part of economic knowledge or economic theories which isused as a tool of analysing business problems for rational business decisions. ManagerialEconomics is often called as Business Economics or Economic for Firms.

Definition of Managerial Economics:

Managerial Economics is economics applied in decision making. It is a special branch of

economics bridging the gap between abstract theory and managerial practice. Haynes, Moteand Paul.

Business Economics consists of the use of economic modes of thought to analyse businesssituations. McNairand Meriam

Business Economics (Managerial Economics) is the integration of economic theory withbusiness practice for the purpose of facilitating decision making and forward planning bymanagement. Spencerand Seegelman.

Managerial economics is concerned with application of economic concepts and economic

analysis to the problems of formulating rational managerial decision. Mansfield

Nature of Managerial Economics:

The primary function of management executive in a business organisation is decisionmaking and forward planning.

Decision making and forward planning go hand in hand with each other. Decisionmaking means the process of selecting one action from two or more alternative courses ofaction. Forward planning means establishing plans for the future to carry out the decisionso taken.

The problem of choice arises because resources at the disposal of a business unit (land,

labour, capital, and managerial capacity) are limited and the firm has to make the mostprofitable use of these resources. The decision making function is that of the business executive, he takes the decision

which will ensure the most efficient means of attaining a desired objective, say profitmaximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go onat the same time.


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A business managers task is made difficult by the uncertainty which surrounds businessdecision-making. Nobody can predict the future course of business conditions. Heprepares the best possible plans for the future depending on past experience and futureoutlook and yet he has to go on revising his plans in the light of new experience tominimise the failure. Managers are thus engaged in a continuous process of decision-

making through an uncertain future and the overall problem confronting them is one ofadjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic

theory can be, pressed into service with considerable advantage as it deals with a numberof concepts and principles which can be used to solve or at least throw some light uponthe problems of business management. E.g are profit, demand, cost, pricing, production,competition, business cycles, national income etc. The way economic analysis can beused towards solving business problems, constitutes the subject-matter of ManagerialEconomics.

Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science.Even then the following fields may be said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting2. Cost and Production Analysis3. Pricing Decisions, Policies and Practices4. Profit Management5. Capital Management

These divisions of business economics constitute its subject matter.

Recently, managerial economists have started making increased use of Operation Researchmethods like Linear programming, inventory models, Games theory, queuing up theory etc.,have also come to be regarded as part of Managerial Economics.

1. Demand Analysis and Forecasting: A business firm is an economic organisation whichis engaged in transforming productive resources into goods that are to be sold in themarket. A major part of managerial decision making depends on accurate estimates ofdemand. A forecast of future sales serves as a guide to management for preparingproduction schedules and employing resources. It will help management to maintain or

strengthen its market position and profit base. Demand analysis also identifies a numberof other factors influencing the demand for a product. Demand analysis and forecastingoccupies a strategic place in Managerial Economics.

2. Cost and production analysis: A firms profitability depends much on its cost ofproduction. A wise manager would prepare cost estimates of a range of output, identifythe factors causing are cause variations in cost estimates and choose the cost-minimisingoutput level, taking also into consideration the degree of uncertainty in production andcost calculations. Production processes are under the charge of engineers but the business


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manager is supposed to carry out the production function analysis in order to avoidwastages of materials and time. Sound pricing practices depend much on cost control.The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.

3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial

Economics. In fact, price is the genesis of the revenue of a firm ad as such the success ofa business firm largely depends on the correctness of the price decisions taken by it. Theimportant aspects dealt with this area are: Price determination in various market forms,pricing methods, differential pricing, product-line pricing and price forecasting.

4. Profit management: Business firms are generally organized for earning profit and in thelong period, it is profit which provides the chief measure of success of a firm. Economicstells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs andrevenues likely to accrue to the firm at different levels of output. The more successful amanager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of

Managerial Economics.5. Capital management: The problems relating to firms capital investments are perhapsthe most complex and troublesome. Capital management implies planning and control ofcapital expenditure because it involves a large sum and moreover the problems indisposing the capital assets off are so complex that they require considerable time andlabour. The main topics dealt with under capital management are cost of capital, rate ofreturn and selection of projects.

Basic economic tools in managerial economics for decision making:

Economic theory offers a variety of concepts and analytical tools which can be of considerable

assistance to the managers in his decision making practice. These tools are helpful for managersin solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

1. Opportunity cost2. Incremental principle3. Principle of the time perspective4. Discounting principle5. Equi-marginal principle

1) Opportunity cost principle:

By the opportunity cost of a decision is meant the sacrifice of alternatives required by thatdecision.

For e.g.


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a) The opportunity cost of the funds employed in ones own business is the interest that could beearned on those funds if they have been employed in other ventures.

b) The opportunity cost of using a machine to produce one product is the earnings forgone whichwould have been possible from other products.

c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate ofinterest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves nosacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevantcosts.

2) Incremental principle:

It is related to the marginal cost and marginal revenues, for economic theory. Incremental

concept involves estimating the impact of decision alternatives on costs and revenue,emphasizing the changes in total cost and total revenue resulting from changes in prices,products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

1. Incremental cost2. Incremental Revenue

The incremental principle may be stated as under:

A decision is obviously a profitable one if

it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues

3) Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects ofdecisions on revenues as well as costs. The very important problem in decision making is to

maintain the right balance between the long run and short run considerations.

For example;

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes tomanagements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the wholelot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. Therefore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)


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Analysis:

From the above example the following long run repercussion of the order is to be taken intoaccount:

1) If the management commits itself with too much of business at lower price or with a smallcontribution it will not have sufficient capacity to take up business with higher contribution.

2) If the other customers come to know about this low price, they may demand a similar lowprice. Such customers may complain of being treated unfairly and feel discriminated against.

In the above example it is therefore important to give due consideration to the time perspectives.a decision should take into account both the short run and long run effects on revenues andcosts and maintain the right balance between long run and short run perspective.

4) Discounting Principle:

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupeetoday. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/-next year. Naturally he will chose Rs.100/- today. This is true for two reasons-

i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the presentopportunity is not availed of

ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to earninterest say as 8% so that one year after Rs.100/- will become 108

5) Equi marginal Principle:

This principle deals with the allocation of an available resource among the alternative activities.According to this principle, an input should be so allocated that the value added by the last unit isthe same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities whichneed labors services, viz, A,B,C and D. it can enhance any one of these activities by adding morelabor but only at the cost of other activities.

The Micro Economics and Macro Economics:

Economic analysis is of two types (a) Micro economic analysis and (b) Macro economic analysis

a) Definition of Micro economics:

According to E. Boulding, Micro economics is the study of particular firm, particularhousehold, individual price, wage, income, industry, and particular commodity.


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In the words ofLeftwitch, Micro economics is concerned with the economic activities of sucheconomic units as consumers, resource owners and business firms.

Micro is a Greek word means small. Micro economic theory studies the behaviour of individual decision-making units such as

consumers resource owners, business firms, individual households, wages of workers,etc. It studies the flow of economic resources or factors of production from the resource

owners to business firms and the flow of goods and services from the business firms tohouseholds. It studies the composition of such flows and how the prices of goods andservices in the flow are determined.

In this analysis economists pick up a small unit and observe the details of its operation. It provides analytical tools for the study of the behaviour of market mechanism. It is also called as Price theory and It is also called as Partial Equilibrium analysis.

Conclusion: Micro economics has been defined as that branch where the unit of study is anindividual, firm or household. It studies how individual make their choices about what toproduce, how to produce, and for whom to produce, and what price to charge. It is also known asthe price theory is the main source of concepts and analytical tools for managerial decisionmaking. Various micro economic concepts such as demand, supply, elasticity of demand andsupply, marginal cost, various market forms, etc. are of great significance to managerialeconomics.

Importance of Micro economics:

Micro economics occupies a very important place in the study of economic theory.

It has both theoretical and practical importance. It explains the functioning of a free enterprise economy. It tells how millions of consumers and producers in an economy take decisions about the

allocation of productive resources among millions of goods and services. It explains how through market mechanism goods and services produced in the

community are distributed. It explains the determination of the relative prices of the various products and productive

services. It helps in the formulation of economic policies calculated to promote efficiency in

production and the welfare of the masses.

Limitations of Micro economics:

It cannot give an idea of the functioning of the economy as a whole. An individualindustry may be flourishing, where as the economy as a whole may be languishing.

It assumes full employment which is a rare phenomenon, at any rate in the capitalistworld. Therefore it is an unrealistic assumption.

b) Definition of Macro economics:


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According to E. BouldingMacro economics deals not with individual quantities as such butwith aggregates of these quantities, not with individual income but with national income not withindividual prices but with price levels, not with individual outputs but with national output.

According to Gardner Ackely, Macro economics concerns with such variables as the aggregate

volume of the output of an economy, with the extent to which its resources are employed, withthe size of national income and with the general price level.

Macro economics is the obverse of microeconomics. It is the study of economic system as a whole. It studies not one economic unit like a firm or an industry but the whole economic

system. Therefore it deals with totals or aggregates national income output and employment, total

consumption, saving and investment and the genera level of prices. It is also called as Income theory and It is also called as aggregative economics.

Conclusion: Macro economics studies the economics as a whole. It is aggregative in characterand takes the entire economic as a unit of study. Macro economics helps in the area offorecasting. It includes National Income, aggregate consumption, investments, employment etc.

Importance of Macro economics:

It helps in understanding the functioning of a complicated economic system It gives a birds eye view of the economic world For the formulation of useful economic policies for the nation macro economics is of the

utmost significance.

It is far more fruitful to regulate aggregate employment and national income and to workout a national wage policy It occupies most important place in economic theory in its pursuit of the solution of

urgent economic problems.

Limitations of Macro economics:

Individual is ignored altogether. It is individual welfare which is the main aim ofeconomics.

It overlooks individual differences. Say the general price level may be stable, but theprice of food grains may have gone spelling ruin to the poor.

Difference between Micro economics and Macro economics:

The main differences between micro economics and macro economics are the following:

S.no Micro economics Macro economics


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Demand for product implies:

a) desires to acquire it,

b) willingness to pay for it, and

c) Ability to pay for it.

All three must be checked to identify and establish demand. For example : A poor mans desiresto stay in a five-star hotel room and his willingness to pay rent for that room is not demand,because he lacks the necessary purchasing power; so it is merely his wishful thinking. Similarly,a misers desire for and his ability to pay for a car is not demand, because he does not have thenecessary willingness to pay for a car. One may also come across a well-established person whoprocesses both the willingness and the ability to pay for higher education. But he has really nodesire to have it, he pays the fees for a regular cause, and eventually does not attend his classes.Thus, in an economics sense, he does not have a demand for higher education degree/diploma.

It should also be noted that the demand for a product-a commodity or a servicehas no meaningunless it is stated with specific reference to the time, its price, price of is related goods,consumers income and tastes etc. This is because demand, as is used in Economics, varies withfluctuations in these factors.

To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it is stated interms of the year, say 1983 when an Atlas cycles price was around Rs. 800, competing cyclesprices were around the same, a scooters prices was around Rs. 5,000. In 1984, the demand foran Atlas cycle could be different if any of the above factors happened to be different. Forexample, instead of domestic (Indian), market, one may be interested in foreign (abroad) market

as well. Naturally the demand estimate will be different. Furthermore, it should be noted that acommodity is defined with reference to its particular quality/brand; if its quality/brand changes,it can be deemed as another commodity.

To sum up, we can say that the demand for a product is the desire for that product backed bywillingness as well as ability to pay for it. It is always defined with reference to a particular time,place, price and given values of other variables on which it depends.

Demand Function and Demand Curve

Demand function is a comprehensive formulation which specifies the factors that influence the

demand for the product. What can be those factors which affect the demand?

For example,

Dx = D (Px, Py, Pz, B, W, A, E, T, U)

Here Dx, stands for demand for item x (say, a car)


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Px, its own price (of the car)

Py, the price of its substitutes (other brands/models)

Pz, the price of its complements (like petrol)

B, the income (budget) of the purchaser (user/consumer)

W, the wealth of the purchaser

A, the advertisement for the product (car)

E, the price expectation of the user

T, taste or preferences of user

U, all other factors.

Briefly we can state the impact of these determinants, as we observe in normal circumstances:

i) Demand for X is inversely related to its own price. As price rises, the demand tends to fall andvice versa.

ii) The demand for X is also influenced by its related priceof goods related to X. For example,if Y is a substitute of X, then as the price of Y goes up, the demand for X also tends to increase,and vice versa. In the same way, if Z goes up and, therefore, the demand for X tends to go up.

iii) The demand for X is also sensitive to price expectation of the consumer; but here, muchwould depend on the psychology of the consumer; there may not be any definite relation.

This is speculative demand. When the price of a share is expected to go up, some people maybuy more of it in their attempt to make future gains; others may buy less of it, rather may disposeit off, to make some immediate gain. Thus the price expectation effect on demand is not certain.

iv) The income (budget position) of the consumer is another important influence on demand. Asincome (real purchasing capacity) goes up, people buy more of normal goods and less ofinferior goods. Thus income effect on demand may be positive as well as negative. Thedemand of a person (or a household) may be influenced not only by the level of his own absolute

income, but also by relative incomehis income relative to his neighbours income and hispurchase pattern. Thus a household may demand a new set of furniture, because his neighbourhas recently renovated his old set of furniture. This is called demonstration effect.

v) Past income or accumulated savings out of that income and expected future income, itsdiscounted value along with the present incomepermanent and transitoryall togetherdetermine the nominal stock of wealth of a person. To this, you may also add his current stock ofassets and other forms of physical capital; finally adjust this to price level. The real wealth of the


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consumer, thus computed, will have an influence on his demand. A person may pool all hisresources to construct the ground floor of his house. If he has access to some additionalresources, he may then construct the first floor rather than buying a flat. Similarly one who has acolor TV (rather than a black-and-white one) may demand a V.C.R./V.C.P. This is regarded asthe real wealth effect on demand.

vi) Advertisement also affects demand. It is observed that the sales revenue of a firm increases inresponse to advertisement up to a point. This is promotional effect on demand (sales). Thus

vii) Tastes, preferences, and habits of individuals have a decisive influence on their pattern ofdemand. Sometimes, even social pressurecustoms, traditions and conventions exercise a stronginfluence on demand. These socio-psychological determinants of demand often defy anytheoretical construction; these are non-economic and non-market factorshighly indeterminate.In some cases, the individual reveal his choice (demand) preferences; in some cases, his choicemay be strongly ordered. We will revisit these concepts in the next unit.

You may now note that there are various determinants of demand, which may be explicitly takencare of in the form of a demand function. By contrast, a demand curve only considers the price-demand relation, other things (factors) remaining the same. This relationship can be illustrated inthe form of a table called demand schedule and the data from the table may be given adiagrammatic representation in the form of a curve. In other words, a generalized demandfunction is a multivariate function whereas the demand curve is a single variable demandfunction.

Dx = D(Px)

In the slopeintercept from, the demand curve which may be stated as


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Dx = + Px, where is the intercept term and the slope which is negative because of inverserelationship between Dx and Px.

Suppose, = (-) 0.5, and = 10

Then the demand function is : D=10-0.5P

TYPES OF DEMAND:

The different types of demand are:

i) Direct and Derived Demands

Direct demand refers to demand for goods meant for final consumption; it is the demand forconsumers goods like food items, readymade garments and houses. By contrast, derived demand

refers to demand for goods which are needed for further production; it is the demand forproducers goods like industrial raw materials, machine tools and equipments.

Thus the demand for an input or what is called a factor of production is a derived demand; itsdemand depends on the demand for output where the input enters. In fact, the quantity of demandfor the final output as well as the degree of substituability/complementarty between inputs woulddetermine the derived demand for a given input.

For example, the demand for gas in a fertilizer plant depends on the amount of fertilizer to be produced and substitutability between gas and coal as the basis for fertilizer production.However, the direct demand for a product is not contingent upon the demand for other products.

ii) Domestic and Industrial Demands

The example of the refrigerator can be restated to distinguish between the demand for domesticconsumption and the demand for industrial use. In case of certain industrial raw materials whichare also used for domestic purpose, this distinction is very meaningful.

For example, coal has both domestic and industrial demand, and the distinction is important fromthe standpoint of pricing and distribution of coal.

iii) Autonomous and Induced Demand

When the demand for a product is tied to the purchase of some parent product, its demand iscalled induced or derived.

For example, the demand for cement is induced by (derived from) the demand for housing. Asstated above, the demand for all producers goods is derived or induced. In addition, even in therealm of consumers goods, we may think of induced demand. Consider the complementaryitems like tea and sugar, bread and butter etc. The demand for butter (sugar) may be induced by


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the purchase of bread (tea). Autonomous demand, on the other hand, is not derived or induced.Unless a product is totally independent of the use of other products, it is difficult to talk aboutautonomous demand. In the present world of dependence, there is hardly any autonomousdemand. Nobody today consumers just a single commodity; everybody consumes a bundle ofcommodities. Even then, all direct demand may be loosely called autonomous.

iv) Perishable and Durable Goods Demands

Both consumers goods and producers goods are further classified into perishable/non-durable/single-use goods and durable/non-perishable/repeated-use goods. The former refers tofinal output like bread or raw material like cement which can be used only once. The latter refersto items like shirt, car or a machine which can be used repeatedly. In other words, we canclassify goods into several categories: single-use consumer goods, single-use producer goods,durable-use consumer goods and durable-use producers goods. This distinction is useful becausedurable products present more complicated problems of demand analysis than perishableproducts. Non-durable items are meant for meeting immediate (current) demand, but durable

items are designed to meet current as well as future demand as they are used over a period oftime. So, when durable items are purchased, they are considered to be an addition to stock ofassets or wealth. Because of continuous use, such assets like furniture or washing machine,suffer depreciation and thus call for replacement. Thus durable goods demand has two varieties replacement of old products and expansion of total stock. Such demands fluctuate with businessconditions, speculation and price expectations. Real wealth effect influences demand forconsumer durables.

v) New and Replacement Demands

This distinction follows readily from the previous one. If the purchase or acquisition of an item is

meant as an addition to stock, it is a new demand. If the purchase of an item is meant formaintaining the old stock of capital/asset, it is replacement demand. Such replacementexpenditure is to overcome depreciation in the existing stock.

Producers goods like machines. The demand for spare parts of a machine is replacementdemand, but the demand for the latest model of a particular machine (say, the latest generationcomputer) is anew demand. In course of preventive maintenance and breakdown maintenance,the engineer and his crew often express their replacement demand, but when a new process or anew technique or anew product is to be introduced, there is always a new demand.

You may now argue that replacement demand is induced by the quantity and quality of the

existing stock, whereas the new demand is of an autonomous type. However, such a distinction ismore of degree than of kind. For example, when demonstration effect operates, a new demandmay also be an induced demand. You may buy a new VCR, because your neighbor has recentlybought one. Yours is a new purchase, yet it is induced by your neighbors demonstration.

vi) Final and Intermediate Demands


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This distinction is again based on the type of goods- final or intermediate. The demand for semi-finished products, industrial raw materials and similar intermediate goods are all deriveddemands, i.e., induced by the demand for final goods. In the context of input-output models, suchdistinction is often employed.

vii) Individual and Market Demands

This distinction is often employed by the economist to study the size of the buyers demand,individual as well as collective. A market is visited by different consumers, consumer differencesdepending on factors like income, age, sex etc. They all react differently to the prevailing marketprice of a commodity. For example, when the price is very high, a low-income buyer may notbuy anything, though a high income buyer may buy something. In such a case, we maydistinguish between the demand of an individual buyer and that of the market which is themarket which is the aggregate of individuals. You may note that both individual and marketdemand schedules (and hence curves, when plotted) obey the law of demand. But the purchasingcapacity varies between individuals. For example, A is a high income consumer, B is a middle-

income consumer and C is in the low-income group. This information is useful for personalizedservice or target-group-planning as a part of sales strategy formulation.

viii) Total Market and Segmented Market Demands

This distinction is made mostly on the same lines as above. Different individual buyers togethermay represent a given market segment; and several market segments together may represent thetotal market. For example, the Hindustan Machine Tools may compute the demand for itswatches in the home and foreign markets separately; and then aggregate them together toestimate the total market demand for its HMT watches. This distinction takes care of differentpatterns of buying behavior and consumers preferences in different segments of the market.

Such market segments may be defined in terms of criteria like location, age, sex, income,nationality, and so on

x) Company and Industry Demands

An industry is the aggregate of firms (companies). Thus the Companys demand is similar to anindividual demand, whereas the industrys demand is similar to aggregated total demand. Youmay examine this distinction from the standpoint of both output and input.

For example, you may think of the demand for cement produced by the Cement Corporation ofIndia (i.e., a companys demand), or the demand for cement produced by all cement

manufacturing units including the CCI (i.e., an industrys demand). Similarly, there may bedemand for engineers by a single firm or demand for engineers by the industry as a whole, whichis an example of demand for an input. You can appreciate that the determinants of a companysdemand may not always be the same as those of an industrys. The inter-firm differences withregard to technology, product quality, financial position, market (demand) share, marketleadership and competitiveness- all these are possible explanatory factors. In fact, a clearunderstanding of the relation between company and industry demands necessitates anunderstanding of different market structures.


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Law of demand:

Suppose you want to buy mangoes at Rs.100 per dozen you buy 6 dozens. If the price ofmangoes increase to 200/- then how much will you buy? Definitely less quantity of goods. Whatkind of relationship is there between the price and quantity demanded? There is inverse relation.

The law of demand states that Ceteris paribus (other things remaining the same), higher theprice, lower the demand and vice versa. The law is stated primarily in terms of the price andquantity relationship. The quantity demanded is inversely related to its price.

Here we consider only two factors i.e. price and quantity demanded.

All the other factors which determine are assumed to be constant. Which are those factors?

Assumptions:

Income of the consumer is constant. There is no change in the availability and the price of the related commodities (i.e.

complimentary and substitutes) There are no expectations of the consumers about changes in the future price and income. Consumers taste and preferences remain the same. There is no change in the population and its structure.

Illustration:

Price (in $)Quantity demanded (in units)

4 40

3 70

2 90

1 100

Take quantity on X axis and price on Y axis. Draw the demand curve and describe it.


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Chief characteristics:

So by observing a demand curve the chief characteristics are;

Inverse relationship between the price and the quantity demanded. This is shown by the

downward sloping demand curve. Price is an independent variable and the demand is dependent. It is the effect of price on

demand and not vice versa.

Reasons underling the law of demand- this inverse relationship can be explained in terms of tworeasons, viz,

1. Income effect: The decline in the price of a commodity leads to an equivalent increase inthe income of a consumer because he has to spend less to buy the same quantity of goods.The part of the money left can be used for buying some more units of commodity. Fore.g. Suppose the price of mangoes falls from Rs.100/- per dozen to 50/- per dozen. Then

with the same amount of 100/- you can buy one more dozen, i.e.,2 dozens at Rs. 50/-2. Substitution effect: When the price of a commodity falls, the consumer tends to

substitute that commodity for other commodity which is relatively dearer. For e.g.Suppose the price of the Urad falls, it will be used by some people in place of otherpulses. Thus the demand will increase.

Exceptions of Law of demand:

1) Conspicuous consumption:

The goods which are purchased for Snob appeal are called as the conspicuous consumption.They are also called as Veblen goods because Veblen coined this term.

For e.g.- diamonds, curios. They are the prestige goods. The would like to hold it only when theyare costly and rare.

So, what can be the policy implication for the manager of a company who produces it? Aproducer can take advantage by charging high premium prices.

2) Speculative market:

in this case the higher the price the higher will be the demand. It happens because of theexpectation to increase the price in the future.

For e.g. shares, lotteries, gamble and ply-win type of markets.

3) Giffens goods:


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It is a special type of inferior goods where the increase in the price results into the increase In thequantity demanded. This happens because these goods are consumed by the poor people whowould like to buy more if the price increases.

For e.g. a poor person who buys inferior quality vegetables. If the price of such vegetable

increase then they prefer to buy because they think that it would be of a better quality

4) Ignorance:

Many a times consumer judges the quality of a good from its price. Such consumers maypurchase high price goods because of the feeling of possessing a better quality.

Demand Forecasting in Managerial Economics:

One of the crucial aspects in which managerial economics differs from pure economic theory liesin the treatment of risk and uncertainty. Traditional economic theory assumes a risk-free world

of certainty; but the real world business is full of all sorts of risk and uncertainty. A managercannot, therefore, afford to ignore risk and uncertainty. The element of risk is associated withfuture which is indefinite and uncertain. To cope with future risk and uncertainty, the managerneeds to predict the future event. The likely future event has to be given form and content interms of projected course of variables, i.e. forecasting. Thus, business forecasting is an essentialingredient of corporate planning. Such forecasting enables the manager to minimize the elementof risk and uncertainty. Demand forecasting is a specific type of business forecasting.

Concepts of Forecasting:

The manager can conceptualize the future in definite terms. If he is concerned with future event-its order, intensity and duration, he can predict the future. If he is concerned with the course offuture variables- like demand, price or profit, he can project the future. Thus prediction andprojection-both have reference to future; in fact, one supplements the other. Suppose, it ispredicted that there will be inflation (event). To establish the nature of this event, one needs toconsider the projected course of general price index (variable). Exactly in the same way, thepredicted event of business recession has to be established with reference to the projected courseof variables like sales, inventory etc.

Projection is of two types forward and backward. It is a forward projection of data variables,

which is named forecasting. By contrast, the backward projection of data may be named backcasting, a tool used by the new economic historians. For practical managers concerned withfuturology, what is relevant is forecasting, the forward projection of data, which supports theproduction of an event.

Thus, if a marketing manager fears demand recession, he must establish its basis in terms oftrends in sales data; he can estimate such trends through extrapolation of his available sales data.This trend estimation is an exercise in forecasting.


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Need for Demand Forecasting

Business managers, depending upon their functional area, need various forecasts. They need toforecast demand, supply, price, profit, costs and returns from investments.

The question may arise: Why have we chosen demand forecasting as a model? What is the use ofdemand forecasting?

The significance of demand or sales forecasting in the context of business policy decisions canhardly be overemphasized. Sales constitute the primary source of revenue for the corporate unitand reduction for sales gives rise to most of the costs incurred by the firm.

Demand forecasting is essential for a firm because it must plan its output to meet the forecasteddemand according to the quantities demanded and the time at which these are demanded. Theforecasting demand helps a firm to arrange for the supplies of the necessary inputs without anywastage of materials and time and also helps a firm to diversify its output to stabilize its income

overtime.

The purpose of demand forecasting differs according to the type of forecasting.

(1) The purpose of the Short term forecasting:

It is difficult to define short run for a firm because its duration may differ according to the natureof the commodity. For a highly sophisticated automatic plant 3 months time may be consideredas short run, while for another plant duration may extend to 6 months or one year. Time durationmay be set for demand forecasting depending upon how frequent the fluctuations in demand are,short- term forecasting can be undertaken by affirm for the following purpose;

Appropriate scheduling of production to avoid problems of over production and under-production.

Proper management of inventories Evolving suitable price strategy to maintain consistent sales Formulating a suitable sales strategy in accordance with the changing pattern of demand

and extent of competition among the firms. Forecasting financial requirements for the short period.

(2) The purpose of long- term forecasting:

The concept of demand forecasting is more relevant to the long-run that the short-run. It iscomparatively easy to forecast the immediate future than to forecast the distant future.Fluctuations of a larger magnitude may take place in the distant future. In fast developingeconomy the duration may go up to 5 or 10 years, while in stagnant economy it may go up to 20years. More over the time duration also depends upon the nature of the product for whichdemand forecasting is to be made. The purposes are;


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Planning for a new project, expansion and modernization of an existing unit,diversification and technological up gradation.

Assessing long term financial needs. It takes time to raise financial resources. Arranging suitable manpower. It can help a firm to arrange for specialized labour force

and personnel.

Evolving a suitable strategy for changing pattern of consumption.

Steps in Demand Forecasting:

Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. Ateach step, you have to make critical considerations. Such considerations are categorically listedbelow:

1) Nature of forecast: To begin with, you should be clear about the uses of forecast data- how itis related to forward planning and corporate planning by the firm. Depending upon its use, youhave to choose the type of forecasts: short-run or long-run, active or passive, conditional or non-

conditional etc.

2) Nature of product: The next important consideration is the nature of product for which youare attempting a demand forecast. You have to examine carefully whether the product isconsumer goods or producer goods, perishable or durable, final or intermediate demand, newdemand or replacement demand type etc. A couple of examples may illustrate the importance ofthis factor. The demand for intermediate goods like basic chemicals is derived from the finaldemand for finished goods like detergents. While forecasting the demand for basic chemicals, itbecomes essential to analyze the nature of demand for detergents. Promoting sales throughadvertising or price competition is much less important in the case of intermediate goodscompared to final goods. The elasticity of demand for intermediate goods depends on their

relative importance in the price of the final product.

Time factor is a crucial determinant in demand forecasting. Perishable commodities such as freshvegetables and fruits can be sold over a limited period of time. Here skilful demand forecastingis needed to avoid waste. If there are storage facilities, then buyers can adjust their demandaccording to availability, price and income. The time taken for such adjustment varies fromproduct to product. Goods of daily necessities that are bought more frequently will lead toquicker adjustments. Whereas in case of expensive equipment which is worn out and replacedafter a long period of time, adaptation of demand will be spread over a longer duration of time.

3) Determinants of demand: Once you have identified the nature of product for which you are

to build a forecast, your next task is to locate clearly the determinants of demand for the product.Depending on the nature of product and nature of forecasts, different determinants will assumedifferent degree of importance in different demand functions.

In the preceding unit, you have been exposed to a number of price-income factors ordeterminants-own price, related price, own income-disposable and discretionary, related income,advertisement, price expectation etc. In addition, it is important to consider socio-psychological


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determinants, specially demographic, sociological and psychological factors affecting demand.Without considering these factors, long-run demand forecasting is not possible.

Such factors are particularly important for long-run active forecasts. The size of population, theage-composition, the location of household unit, the sex-composition-all these exercise influence

on demand in. varying degrees. If more babies are born, more will be the demand for toys; ifmore youngsters marry, more will be the demand for furniture; if more old people survive, morewill be the demand for sticks. In the same way buyers psychology-his need, social status, ego,demonstration effect etc. also effect demand. While forecasting you cannot neglect thesefactors.

4) Analysis of factors &determinants: Identifying the determinants alone would not do, theiranalysis is also important for demand forecasting. In an analysis of statistical demand function, itis customary to classify the explanatory factors into (a) trend factors, which affect demand overlong-run, (b) cyclical factors whose effects on demand are periodic in nature, (c) seasonalfactors, which are a little more certain compared to cyclical factors, because there is some

regularly with regard to their occurrence, and (d) random factors which create disturbancebecause they are erratic in nature; their operation and effects are not very orderly.

An analysis of factors is specially important depending upon whether it is the aggregate demandin the economy or the industrys demand or the companys demand or the consumers; demandwhich is being predicted. Also, for a long-run demand forecast, trend factors are important; butfor a short-run demand forecast, cyclical and seasonal factors are important.

5) Choice of techniques: This is a very important step. You have to choose a particulartechnique from among various techniques of demand forecasting. Subsequently, you will beexposed to all such techniques, statistical or otherwise. You will find that different techniques

may be appropriate for forecasting demand for different products depending upon their nature. Insome cases, it may be possible to use more than one technique. However, the choice of techniquehas to be logical and appropriate; for it is a very critical choice. Much of the accuracy andrelevance of the forecast data depends accuracy required, reference period of the forecast,complexity of the relationship postulated in the demand function, available time for forecastingexercise, size of cost budget for the forecast etc.

6) Testing accuracy: This is the final step in demand forecasting. There are various methods fortesting statistical accuracy in a given forecast. Some of them are simple and inexpensive, othersquite complex and difficult. This stating is needed to avoid/reduce the margin of error andthereby improve its validity for practical decision-making purpose. Subsequently you will beexposed briefly to some of these methods and their uses.

TECHNIQUES OF DEMAND FORECASTING:

Broadly speaking, there are two approaches to demand forecasting- one is to obtain informationabout the likely purchase behavior of the buyer through collecting experts opinion or byconducting interviews with consumers, the other is to use past experience as a guide through aset of statistical techniques. Both these methods rely on varying degrees of judgment. The first


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method is usually found suitable for short-term forecasting, the latter for long-term forecasting.There are specific techniques which fall under each of these broad methods.

Simple Survey Method:

For forecasting the demand for existing product, such survey methods are often employed. In thisset of methods, we may undertake the following exercise.

1) Experts Opinion Poll: In this method, the experts on the particular product whose demand isunder study are requested to give their opinion or feel about the product. These experts,dealing in the same or similar product, are able to predict the likely sales of a given product infuture periods under different conditions based on their experience. If the number of such expertsis large and their experience-based reactions are different, then an average-simple or weighted is found to lead to unique forecasts. Sometimes this method is also called the hunch method butit replaces analysis by opinions and it can thus turn out to be highly subjective in nature.

2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here isan attempt to arrive at a consensus in an uncertain area by questioning a group of expertsrepeatedly until the responses appear to converge along a single line. The participants aresupplied with responses to previous questions (including seasonings from others in the group bya coordinator or a leader or operator of some sort). Such feedback may result in an expertrevising his earlier opinion. This may lead to a narrowing down of the divergent views (of theexperts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus generatesreasoned opinion in place of unstructured opinion; but this is still a poor proxy for marketbehavior of economic variables.

3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster undertakes

a complete survey of all consumers whose demand he intends to forecast, Once this informationis collected, the sales forecasts are obtained by simply adding the probable demands of allconsumers. The principle merit of this method is that the forecaster does not introduce any biasor value judgment of his own. He simply records the data and aggregates. But it is a very tediousand cumbersome process; it is not feasible where a large number of consumers are involved.Moreover if the data are wrongly recorded, this method will be totally useless.

4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a fewconsuming units out of the relevant population and then collects data on their probable demandsfor the product during the forecast period. The total demand of sample units is finally blown upto generate the total demand forecast. Compared to the former survey, this method is less tedious

and less costly, and subject to less data error; but the choice of sample is very critical. If thesample is properly chosen, then it will yield dependable results; otherwise there may be samplingerror. The sampling error can decrease with every increase in sample size

5) End-user Method of Consumers Survey: Under this method, the sales of a product areprojected through a survey of its end-users. A product is used for final consumption or as anintermediate product in the production of other goods in the domestic market, or it may beexported as well as imported. The demands for final consumption and exports net of imports are


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estimated through some other forecasting method, and its demand for intermediate use isestimated through a survey of its user industries.

Complex Statistical Methods:

We shall now move from simple to complex set of methods of demand forecasting. Suchmethods are taken usually from statistics. As such, you may be quite familiar with some thestatistical tools and techniques, as a part of quantitative methods for business decisions.

(1) Time series analysis or trend method: Under this method, the time series data on the underforecast are used to fit a trend line or curve either graphically or through statistical method ofLeast Squares. The trend line is worked out by fitting a trend equation to time series data withthe aid of an estimation method. The trend equation could take either a linear or any kind of non-linear form. The trend method outlined above often yields a dependable forecast. The advantagein this method is that it does not require the formal knowledge of economic theory and themarket, it only needs the time series data. The only limitation in this method is that it assumes

that the past is repeated in future. Also, it is an appropriate method for long-run forecasts, butinappropriate for short-run forecasts. Sometimes the time series analysis may not reveal asignificant trend of any kind. In that case, the moving average method or exponentially weightedmoving average method is used to smoothen the series.

(2) Barometric Techniques or Lead-Lag indicators method: This consists in discovering a setof series of some variables which exhibit a close association in their movement over a period ortime.

For example, it shows the movement of agricultural income (AY series) and the sale of tractors(ST series). The movement of AY is similar to that of ST, but the movement in ST takes place

after a years time lag compared to the movement in AY. Thus if one knows the direction of themovement in agriculture income (AY), one can predict the direction of movement of tractorssale (ST) for the next year. Thus agricultural income (AY) may be used as a barometer (a leadingindicator) to help the short-term forecast for the sale of tractors.

Generally, this barometric method has been used in some of the developed countries forpredicting business cycles situation. For this purpose, some countries construct what are knownas diffusion indices by combining the movement of a number of leading series in the economyso that turning points in business activity could be discovered well in advance. Some of thelimitations of this method may be noted however. The leading indicator method does not tell youanything about the magnitude of the change that can be expected in the lagging series, but only

the direction of change. Also, the lead period itself may change overtime. Through ourestimation we may find out the best-fitted lag period on the past data, but the same may not betrue for the future. Finally, it may not be always possible to find out the leading, lagging orcoincident indicators of the variable for which a demand forecast is being attempted.

3) Correlation and Regression: These involve the use of econometric methods to determine thenature and degree of association between/among a set of variables. Econometrics, you mayrecall, is the use of economic theory, statistical analysis and mathematical functions to determine


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the relationship between a dependent variable (say, sales) and one or more independent variables(like price, income, advertisement etc.). The relationship may be expressed in the form of ademand function, as we have seen earlier. Such relationships, based on past data can be used forforecasting. The analysis can be carried with varying degrees of complexity. Here we shall notget into the methods of finding out correlation coefficient or regression equation; you must

have covered those statistical techniques as a part of quantitative methods. Similarly, we shallnot go into the question of economic theory. We shall concentrate simply on the use of theseeconometric techniques in forecasting.

We are on the realm of multiple regression and multiple correlation. The form of the equationmay be:

DX = a + b1 A + b2PX + b3Py

You know that the regression coefficients b1, b2, b3 and b4 are the components of relevantelasticity of demand. For example, b1 is a component of price elasticity of demand. The reflect

the direction as well as proportion of change in demand for x as a result of a change in any of itsexplanatory variables. For example, b2< 0 suggest that DX and PX are inversely related; b4 > 0suggest that x and y are substitutes; b3 > 0 suggest that x is a normal commodity with commoditywith positive income-effect.

Given the estimated value of and b i, you may forecast the expected sales (DX), if you know thefuture values of explanatory variables like own price (PX), related price (Py), income (B) andadvertisement (A). Lastly, you may also recall that the statistics R2 (Co-efficient ofdetermination) gives the measure of goodness of fit. The closer it is to unity, the better is the fit,and that way you get a more reliable forecast.

The principle advantage of this method is that it is prescriptive as well descriptive. That is,besides generating demand forecast, it explains why the demand is what it is. In other words, thistechnique has got both explanatory and predictive value. The regression method is neithermechanistic like the trend method nor subjective like the opinion poll method. In this method offorecasting, you may use not only time-series data but also cross section data. The onlyprecaution you need to take is that data analysis should be based on the logic of economic theory.

(4) Simultaneous Equations Method: Here is a very sophisticated method of forecasting. It isalso known as the complete system approach or econometric model building. In your earlierunits, we have made reference to such econometric models. Presently we do not intend to getinto the details of this method because it is a subject by itself. Moreover, this method is normally

used in macro-level forecasting for the economy as a whole; in this course, our focus is limited tomicro elements only. Of course, you, as corporate managers, should know the basic elements insuch an approach.

The method is indeed very complicated. However, in the days of computer, when packageprogrammes are available, this method can be used easily to derive meaningful forecasts. Theprinciple advantage in this method is that the forecaster needs to estimate the future values ofonly the exogenous variables unlike the regression method where he has to predict the future


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values of all, endogenous and exogenous variables affecting the variable under forecast. Thevalues of exogenous variables are easier to predict than those of the endogenous variables.However, such econometric models have limitations, similar to that of regression method.

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