A Group Assignment on Business Economics
1) Define managerial economics. Show the relationship in between managerial
economics to other disciplines. Explain the scope of managerial
economics?
Managerial Economics is a new subject and its origin is not so old. It came
into existence only in the early 1950s. Formerly it was called business economics but
it became widely known as Managerial Economics.
Managerial economics is very close to traditional economics. It is basically
based on the theories and principles of traditional economics such as demand
analysis, production analysis, pricing theories and practices, theories of profit etc.
But in broad sense, it differs from the traditional economics. It draws heavily from
other disciplines such as accounting, management, statistics and mathematics.
Among micro and macro economics, managerial economics is only concerned with
the later one. Rather than studying individuals, it studies the behavior of the firm and
its activities. The theories which have applied value are studied under it. It helps in
the selection of the best alternatives in the firm which is often called decision making.
Managerial economics is pragmatic which stress on real business world. It is
concerned with those analytical tools and techniques which are useful or likely to be
so as to improve the decision making process within a firm. Managerial economics is
normative rather than positive science. It can also be defined as applied science.
The definition of Managerial economics given by some popular economists is
significant to analyze. Its definition as defined by economists is given here:
“Managerial economics is the application of economic theory and
methodology to business administration practice. More specifically, managerial
economics is the use of tools and techniques of economic analysis to analyze and
solve managerial problems.”
- Pappas and Brigham
“Managerial economics is the integration of economic theory with business
practice for the purpose of facilitating decision – making and forward planning by the
management”
- Spencer and Siegelman
“Managerial economics is a fundamental academic subject which seeks to
understand and to analyze the problems of business decision-making.”
- D.C. Hague
“Managerial economics should be thought as applied micro economics. That
is managerial economics is an application of that part of micro economics focusing
on those topics of greatest interest and importance to managers. These topics
include demand, production, cost, pricing, and market structure and government
regulation.”
– Peterson and Lewis
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A Group Assignment on Business Economics
“Managerial economics is concerned with application of economic concept
and economic analysis to the problem of formulating rational managerial decisions.”
- Edwin Mansfield
Thus, after analyzing the above stated definition of managerial decision, it can be
concluded that, the definition related to decision-making are widely accepted.



Managerial economics is the application of economics theory particularly microeconomic theory to practical problem solving.
Managerial economics is the basic tool for optimum and rational management
decisions.
Managerial economics pertains to the decision making about the optimum
allocation of scarce resources to competing activities.
It can assist the manger:
 by increasing understanding of the market environment
 by providing decision making tools
 by providing theories and methods of analysis and thoughts and
 Ultimately helping to tackle the problem of firm in an efficient way.
Traditional economics
theory and methodology
Business administration
decision problem
Decision science tools
and techniques of
Analysis
Management economics application of economics theory and
Methodology to solving business problems
Optimum solution
Business problem
Linking traditional economics with decision science by managerial economics
As already stated, managerial economics is widely related with various
disciplines. It integrates the concepts and methods from all of these disciplines and
brings them together to solve the managerial problems by the aid of appropriate
decision making.
“Managerial economics is a subject using the logic of Economics, Mathmetics and
statistics to provide effective way of thinking about business decision problems."
- D.C Hague
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A Group Assignment on Business Economics
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCPLINES
The relationship of managerial economics with other subjects to know better the
nature and scope of it is indeed necessary. Hence it is discussed below:
a) Relation with Mathematics and Statistics:
For predicting relevant economic quantities and using the in decision-making and
forward planning, mathematics acts as a facilitator by helping to estimate various
economic relationships. Similarly for the estimation of the relationship between
important variables in decision problems, statistics provides several tools. For
forecasting demand, trend projections, regression techniques, co-relation, leastsquare methods are widely used. Managers do not usually have exact
information about the variables affecting decisions and have to deal with the
uncertainty of future events. The theory of probability provides the logic for
dealing with such uncertainty. Linear programming, an important statistical tool is
used in managerial economics for finding the best solutions or the best
alternatives. It provides information regarding reports, trends, figures and other
data.
b) Relation with traditional economics:
Managerial economics however is distinct subject; it has very much close
relationship with the traditional economics which deals with Microeconomics and
Macroeconomics. Since all the areas of traditional economics are useful for
business firms, managerial economics draws heavily from it too. Though, both
micro and macro economics are important in managerial economics, micro
economic theory of the firm is significantly studied. The economic concepts of
elasticity of demand, propensity to consume, marginal revenue product,
opportunity cost, speculative motive, liquidity preference theory, public finance,
money and banking, national income, theory of international trade, economics of
developing country and national income are equally important in managerial
economics.
In the words of Hynes, "The relation of managerial economics to economic
theory is much like that of engineering to physics, or of medicine to biology or
bacteriology.” It is the abstract basic discipline from which it borrows concepts
and analytical tools.
c) Relation with Accountancy:
Accountancy is concerned with recording the financial operations of a business
firm. Accounting information is one of the primary sources of data required by a
managerial economist for decision making. In a smaller firm the management
accountant himself applies the logic of managerial economics. In contrast, in big
firms, he is one of those helping to provide data so that decision makers can
apply the logic of managerial economics to decision-making.
The main task of management accounting is to provide the sort of data which
manager need if they are to apply the ideas of managerial economics to solve
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A Group Assignment on Business Economics
business problem correctly. The data should be provided in such a way that it fits
easily into the concept and analysis of managerial economics.
d) Relation with Business Administration:
Business administration is organized into four major categories: functional areas,
tool areas, special areas and integrating courses. Managerial economics fit into
the classification of business administration studies into two places. First, it
serves a tool course, where in certain economic theories, methods and
techniques of analysis are covered for their later use in the fundamental areas.
Second, it serves as an integrating course, combining the various functional
areas and showing not only how they interact with on another as the firm
attempts to achieve its goals, but also how firm interacts with the environment in
which it operates, hence managerial economics is a part of study of business
administration.
Managerial economics fit into the classification of business administration studies
in two places. First, it serves as a tool courses, where in certain economic
theories, methods, and techniques of analysis are covered in preparation for their
later use in the functional areas. Second, managerial economics serves as an
integrating course, combining the various functional areas and showing not only
how they interact with one another as the firm attempts to achieve in goal, but
also how the firm interacts with the environment in while it operates.
e) Relation with operations research:
Operations research is the application of mathematical technique to the solving
the business problems. Operations research team consists of experts of various
fields such as mathematics, economics, psychology sociology etc. Both
operations research and managerial economics are concerned with taking
effective decisions in order to reach given objectives. The game theory,
technique of inventory control developed by operations research is used in
managerial economics.
The significant relationship between managerial economics and operation
research can be highlighted with reference to certain important problem of
managerial economics which are solved with the help of operational research
techniques. The problems are allocation problems, competition problems, waiting
line problem and inventory problem.
Allocation problem signifies that men, machines and other resources are scarce.
Competition problem deals with the situations where managerial decision making
is to be made in the face of competitive action.
Waiting line problem arises when a firm wants to known how many machines it
should install in order to ensure that amount of WIP waiting to be machined is
neither small nor large.
Inventory problem deals with optimum level of stock of row material, component
or finished goods.
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A Group Assignment on Business Economics
Thus, managerial economics draws heavily from the above mentioned
disciplines and it directly interacts with the economics variables with the aid of
various disciplines.
SCOPE OF MANAGERIAL ECONOMICS
After discussing about the relationship of managerial economics with other
disciplines, it is significant to list out the scope of managerial economics. The
aspects /scope may also be called the subject matter or area of studies of
managerial economics. The are listed below and are discussed briefly.
i. Demand Analysis and Forecasting:
Demand analysis is useful to identify the various factors that influence the
demand for a firm’s product. It provides guidelines to manipulate the demand.
Accurate estimate of demands affects the managerial decision making. A
forecast of future sales is essential before going for production and employing
resources. This forecast helps to maintain and strengthen the market of the firm
and in turn it will yield more profit.
Demand analysis helps identifying the various factors influencing the demand for
the firm product and thus provide guideline to manipulate demand. Thus, demand
analysis and forecasting is essential for business planning and occupies a
strategic place in managerial economics.
ii. Capital Management:
One of the difficult problems of a business manager is relating to a firm's capital
investments. The large sums are involved in the business and the problems are
numerous. Thus, capital management is required, which in turn, needs
considerable time and labor. Capital management means planning and control of
capital expenditures. The main aspects covered here are: cost of capital, types of
investment decisions, evaluation and selection of projects.
iii. Objectives of the firm:
Every firm has an objective. A firm should fix its objectives at the very outset of
the business. Because, it is the objective, which guides a firm in making
decisions regarding its prices and outputs. The objective may be many ranging
from profit maximization to sales maximization to utility maximization to satisfying.
However, a firm may have one objective at a time. The theories regarding the
objectives of a firm propounded by various economists are studied under it.
iv. Pricing Decisions and Methods:
Pricing decision occupies an important place in managerial economics. Because,
the main objective of a firm is to maximize profits, which depends largely on
appropriate pricing decisions. Since price is the source of the revenue, the
success of a firm depends on the correctness of the pricing decisions. The main
topics covered under it are: price determination under different market structures,
pricing objectives, pricing methods, price discrimination, pricing of joint products.
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A Group Assignment on Business Economics
v. Cost and Production analysis:
The cost estimates are useful for managerial decisions. The factors affecting cost
must be identified to make cost estimates. The cost estimate is essential for
planning purposes. The factors determining costs are not always known or
controllable. This gives rise to uncertainty. It is necessary to discover the
economic costs and measure them for profit planning, cost control and sound
pricing practices.
vi. Business environment
The business environment has significant influence on business firms. Hence,
managerial economics also studies about business environment. The phase of
business cycle, situation of money and capital market, market structure and so on
is studied under business environment.
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A Group Assignment on Business Economics
2) Sales Revenue maximization model is ultimate objective of business
organization. Critically explain.
The model of sales revenue maximization was propounded by W.J. Baumol.
He challenged the assumption of profit maximization and argued that maximization
of sales rather than profit is the ultimate objective of the firm. So, a firm should direct
its energies in promoting and maximizing sales. By sales he meant the revenue
earned by selling the product. The therefore called his hypothesis as Sales
Maximization Hypothesis or Revenue Maximization Hypothesis.
According to him sales maximization means maximizing total revenue from
sales rather than maximizing physical quantity of sales. He has not altogether
ignored profit. His view is that, firms need minimum profit for its expansion plan,
make dividend to attract stock buyers, spend to increase long-term sales and to
provide better return to the shareholders. His point of view is that oligopolists
typically seek to maximize their sales subject to a minimum of profit constraint. It
means the entrepreneurs do not completely neglect costs and profit. The costs
incurred should be covered and usual rate of return on investment be made.
Baumol states that the managers are interested more in sales maximization
than profit. Since ownership and management in modern business are separate
managers deviate from profit maximization and maximize their own utility. Following
are the reasons for the existence of such mentality in top management:
 The relation of salary and other facilities of the top management are more with
sales than profit.
 Since more salary and facilities can be provided to the employees of all levels it
is easier to solve personnel problem.
 Banks and financial institutions like to make available finance to the firms
having increased sales.
 The large and increased sales strengthen the power to adopt competitive
strategy.
 While large sales augment the prestige of the management, large profit goes to
the pockets of shareholders.
 Managers want steady performance with satisfactory profit instead of unique
profit maximization.
Baumol model of Sales maximization has following assumptions:
 The time-horizon of the firm is one period.
 The firm should earn minimum profit to keep shareholders happy and prevent
the fall in share price.
 In the time period the firm tries to maximize total sales revenue subject to profit
constraint instead of physical quantity of output.
 The traditional concept of cost and revenue is valid in which cost curves are "Ushaped" and demand curve is downward sloping.
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A Group Assignment on Business Economics
Under sales Maximization objective output is greater and price lower than under
the objective of profit maximization. Hence, Baumol has explained two types of
equilibrium under sales maximization objective. They are:
a) No profit constraint to sales maximization, and
b) Profit constraint to sales maximization.
1) No profit constraint to sales maximization:
Under this objective firm tries to maximize the sales without having minimum level
of profit constraint. Under this condition, it is assumed that managers are rational
enough not to produce the output incurring losses unless additional financial
support or subsidy is provided by other organization or government agencies. The
objective of social welfare is indeed met under this condition. It can be explained
more with the help of the diagram.
D
C
E
TC
B
TR
A
TC
TP
Q1
Q3
Q2
Q4
Q5 TP
In the given diagram, TR and TC are total revenue and total cost curve, TP is the
total profit curve, which reveals the distant between TR and TC at various level of
output. TR and TC intersect at point A and B, which are known as break-even point,
at which the firm neither enjoys profit nor suffer loss. It should be remembered that
our objective is sales maximization rather then profit maximization without any profit
constraint we can produce output at OQ1 and OQ4. But OQ is obviously rejected
because OQ1 in not the sales maximizing output given that no profit constraint is
existed. Similarly OQ2 and OQ3 output are also rejected because OQ2 is the required
output of profit maximization where profit is highest and OQ3 also there is profit factor
having ample possibility of increasing sales without incurring loss. Thus OQ4 and
OQ5 are only possible level of output where a sale is maximized. OQ 4 is the sales
maximization output given that no financial aid has been provided where the firm
neither suffers loss nor enjoys profit. But if the financial support or subsidy is
provided to cover the loss the firm increases the sales beyond pint OQ 4 to OQ5 and
so on. At OQ5 output TC curve is above TR curve and firm has incurred loss i.e. TP
is negative. Thus, subsidy is necessary to make the firm produce output at OQ5 level
of output. Thus, the possible level of output at sales maximization without profit
constraint model are OQ4 and OQ5.
2) Profit Constraint to Sales Maximization:
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A Group Assignment on Business Economics
Under this model of sales maximization objective, firm tries to maximize sales
with certain predetermined level of profit constraint. Minimum level of profit
constraint has been imposed under the assumption that the firm should earn
minimum profit from shareholder and other stakeholder perspectives. According
to Baumol, minimum profit is required in the business for the long run concept.
So, this model is related with obtaining reasonable profit. How the firm maximizes
the sales with minimum profit constraint can be explained with the help of figure
as well.
TC
TR
B
TC
TR
A
TP
D
C
M
Q1
Q4
Q2
Q5
L
Q3
TP
In the figure, TR and TC and total revenue and total cost curve which intersect
at points A and B, which are known as breakeven point because at this point. The
firm neither loss nor enjoys profit
In the above diagram 'ML' is the minimum profit constraint. 'TP' is the total
profit line, minimum profit like intersects the total profit line at 'C' and 'D'. From the
minimum profit perspective, both the point gives required minimum profit to the firm,
i.e., CQ4 is equal to DQ5. It is obvious from the figure that OQ1 and OQ3 can't be
required level of output because minimum profit is not satisfied at these level of
output. Similarly OQ2 is not also the required level of output. OQ2 is the profit
maximization level of output where profit is above the minimum level. It also proves
that only possible output levels are OQ4 and OQ5. Between these output levels, firm
can't produce OQ4 level of output because although minimum profit constraint
condition has been meeting at this point, sales have not been maximized. These are
ample opportunity to produce higher level of output at same profit level. Thus, no
rational manager would produce output level OQ4. Therefore only possible level of
output is OQ5 where both the conditions of sales maximization and minimum profit
level have been met.
Criticism of Sales- Maximization Objective:
Although the sales maximization advocates the welfare of consumer as well
as the employees and society as a whole, it has been severely criticized by various
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A Group Assignment on Business Economics
economists. The reason on the basis of which this objective has been criticized are
as follows: 1. Sales maximization is consistent with long run profit maximization. A firm can
sacrifice profit in short run to establish itself in market. Once it is established in
market eventually firm is expected to be profit maximization.
2. The firm can sale more than profit maximizing level only due to the ignorance of
their demand curve. If the firm sales more it does not consider maximizing sales
rather then profit.
3. This model has the unacceptable implication that whenever profits above the
minimum required level are earned managers would derive extra satisfaction
from huge outlays an advertising which brought negligible increase in sales and
large reduction in profit.
4. Less misuse of resources and increase in the welfare of the society is not always
necessarily true. It depends in the shape of the demand and cost curves and the
method of measuring output of the society.
5. In the long run both profit maximization and sales maximization hypothesis give
same solution. Because, in the long run profit reaches to normal level and
coincides with minimum profit constraint attainable maximum profit level.
6. Sales maximization theory does not show how the equilibrium of the industry
consisting of all firms as sales maximization is attained. Hence, relationship
between firm and industry has been neglected.
7. Baumol has implicitly assumed that the firm has market power and controls its
price and expansion policy, which is not possible in reality.
8. Baumol Seems to have ignored mutual interdependence, but the firm can not
make the decision without any effect of reaction of rivals.
9. This theory has not only ignored actual competition but also the threat of potential
competition. This theory which also fails to imagine that if a firm could take the
share of a firm or other industry its right on expanding sales is hampered by
reaction.
Although the Baumol's sales maximization theory has been severely criticized,
the following aspects have made this objective the best among the various objective
of a firm:

Sufficient supply of output at lower price enhances the social welfare in
society.

Sales maximization objective has been postulated on the ground that
minimum profit is necessary for the business firm. It will improve the long run
sustainability of the business firm.
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A Group Assignment on Business Economics

Sales maximization model has been advocated from the long run perspective.
Specifically, It is a long run objective of the firm. Profit maximization is short
run objective which is not desirable from social point of view.

Sales maximization objective has been explained from the management
perspective. The objective of owner can only be met with the simultaneous
welfare of the management. Which is based on the reality because
management and ownership is quite different in today’s modern corporate
firm?

Sales revenue maximization objective of Baumol has emphasized on
advertisement to increase the sales, which include the product design, and
increase in research and development expenditure as well.

Sales maximization objective also emphasize the optimum and efficient
utilization of resources. As the firm tries to maximize sales by reducing cost,
there will be less misuse of resources and welfare of society will increase.
Although there has been a lot of shortcoming in the sales maximization
objective, but still it can be described as a relatively suitable objective of the
firm.
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A Group Assignment on Business Economics
3) Explain various types of elasticity of demand. What are their uses in
business decision making?
Law of demand explains the inverse relationship between price and demand
of a commodity. It states that the demand of a commodity increases on a fall in its
price and decreases on increases in its price, but it does not tell the extent to which
the demand will change in response to a given change in the price of a commodity.
Thus, the law of demand is only a qualitative statement and not a quantitative
statement. Prof. Marshall introduced the concept of elasticity of demand to
measure the change in demand. Elasticity of demand is the measurement of the
change in demand in response to a given change in the price of a commodity. It
measures how much demand will change in response to a certain increase or
decrease in the price of a commodity.
According to Pappas and Brigham – “Demand elasticity can be defined as
the percentage change in quantity demanded resulting form a one percent change in
the value of one of the demand determining variables.”
According to demand sensitiveness its determinants, elasticity may be high or
low. The main determinants of demand are price, income, substitution goods and
complementary goods etc.
Thus, elasticity of demand is defined as the percentage change in a
dependent variable Y (quantity demanded) resulting from a 1 percent change in an
independent variable X. The equation for calculating elasticity is:
Elasticity =
PercentageChangeinY
PercentageChangeinX
Thus, elasticity of demand can be defined as the responsiveness of demand
to the changes in its determinants such as either price or income or advertisement
expenditure or price of the related goods etc. The effects of these changes are
measured by price elasticity income elasticity, advertisement elasticity and cross
elasticity of demand respectively.
Types of Elasticity of Demand:
There are various concept of elasticity of demand, important of which used in
business decision are:
a) Price Elasticity of Demand
b) Income Elasticity of Demand
c) Cross Elasticity of demand
a) Price elasticity of Demand
Price elasticity of demand is generally defined as the responsiveness or
sensitiveness of demand for a commodity to the changes in its price. More,
precisely, elasticity of demand is the percentage changes in demand as a result
of one percent in the price of the commodity. The formal definition of priceelasticity of demand (eP) is given as
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A Group Assignment on Business Economics
Percentagechangeinquantitydemanded
Percentagechangeinprice
d2
d2 p
ep =
= . 
X 100
2
2 dp
dp
X 100
p
ep =
d2
dp
.
p
2
Where,
Q= Original quantity demanded
P= Original Price
dQ = Change in quantity demanded
dp = Change in Price
Price elasticity of demanded is always Negative for normal goods as there is
inverse relationship between quantity demanded and price.
Types of price Elasticity
(1) Perfectly elastic demand: ep = ∞
When the demand of a commodity changes to any extent without any change in
to price or on a very little change in it's price, it is known as perfectly elastic
demand. It is to remember that such elasticity of demand is only imaginary
because in real life there is no commodity having perfectly elastic demand. With
perfectly demand all output are sold at a fined price.
PX
Ep = ∞
DX
O
(II) Perfectly Inelastic Demand: Ep = 0
When the demand of a commodity does not change whatever be the change in
its price it is called perfectly inelastic demand.
PX
O
Ep = 0
DX
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A Group Assignment on Business Economics
(II) Relatively Elastic Demand: Ep>1
When proportionate change in the quantity in the quantity demanded of a product
is more than the proportionate change in its price, it is called relatively elastic
demand.
P
X
P1
P2
P3
Ep>1
0
DX
Q1 Q Q2
(IV) Relatively Inelastic Demand: Ep<1
When proportionate change in the demand of a commodity is less than the
proportionate change in its price, it is known as relatively inelastic demand.
PX
Ep<1
P1
P
P2
0
DX
Q1 Q Q2
(V) Unitary Elastic Demand: Ep=1
When proportionate change in the price of a commodity and proportionate
change in its demand are equal, it is called unitary elastic demand.
PX
EP=1
P1
P
P2
O
Q1 Q
p2
DX
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A Group Assignment on Business Economics
Use of price elasticity in Business Decisions.
The use of price elasticity of demand is as follows:
1. Product pricing:
Firms need to be aware of the elasticity of their product when they price their
products. For example if demand is elastic, it is desirable to reduce price. On
other hand, if demand is inelastic, it is desirable to increase price. But in case of
business or commodities having substitutes, price increase leads to low sales
and profit is reduced.
The firm in imperfect competition including monopoly has to know the price
elasticity of demand in determination of price. If the elasticity of demand for the
product is inelastic, firms can charge high price. If the demand is elastic the firms
have to lose the customer if the price is increased. The monopoly firm, though
has the power to fix the price of its product has to consider elasticity while
determining price.
A monopolist adopts a price discrimination policy only when he finds the elasticity
of demand of different consumers or sub- markets is different. If demand is
inelastic, he can charge high price than those with more elastic demand.
2. Pricing of the factors of production:
The concept of elasticity of demand is useful in the determination for price of
factors of production. If the demands for factors of production are more elastic the
producers are prepared to pay high price for these factors. Like wise, If the
demand for the factors of production is elastic the producers are prepared to pay
low price for the factors.
3. Pricing of joint products:
Certain goods, being products of the same process are jointly supplied, e.g. wool
and mutton, compress and refrigerator etc. Hence if the demand for one product
say, wool is inelastic compared to another say, demand for mutton, a higher price
for wool can be charged.
4. Demand forecasting:
The concept of elasticity to demand helps the firms in demand forecasting.
Demand forecasting is essential for the firms to make production, marketing
financial, and personnel decisions. The firms can make necessary arrangement
for raw materials, inventory personnel and finance for production on the basis of
expected demand .If the demand for the product is elastic, demand may be
expected to increase in future.
5. Discount decision:
The knowledge of price elasticity of demand is essential in management decision
in the field of discount decision. It is clean from the matter that whether airline
services should give discount or should reduce fare or not. The revenue per
passenger decreases when fare is reduced but the number of passenger
increases. How far the increases passenger compensates the decreased
revenue depends on the elasticity of demand of traveling by airplane.
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A Group Assignment on Business Economics
6. Estimate Revenue:
Knowledge of price elasticity is very much important while estimating revenue.
This means, if demand is elastic, a reduction in price would increase total
revenue. On the contrary, if demand is inelastic and increase in price would
increase total revenue and if is unitary no revenue effects will be there what ever
changes in prices.
B) Income Elasticity of demand:
The level of consumer's income is a very important determinant of demand.
Income elasticity can be defined as the degree or responsiveness or
sensitiveness of demand to the change in consumer's income. In other word, the
income elasticity of demand for particular goods is defined to be the percentage
in quantity demanded resulting from 1 percent change in consumer's income.
The formula to measure income elasticity is:
Proportionate change in quality demand
EY=
Proportionate change in income
Change in quantity demanded
Quantity Demanded
or, EY =
Change in income
Income
Symbolically,
EY=
q
y
x
q
q
=
q
y
x
q
q
Types of Income Elasticity
There are three types of income elasticity.
1. Zero Income elasticity: E1 = 0
In this case a change in income will have no effect on the quantities demanded
e.g. salt.
2. Negative Income elasticity: E1< 0
In this case an increase in income may lead to a reduction in the quantities
demanded. Such happens in inferior goods for example, an increase in income
might lead one to shift in his demand from Bidies to cigarettes.
3. Positive income elasticity: E1 > 0
An increase in income in income may lead to an increase in the quantities
demanded for most goods. E1>0 i.e. when income rises demand also rises such
goods are known as superior goods. Positive income elasticity can be of three
kinds; unitary elasticity, more than unitary elasticity and less than unitary
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A Group Assignment on Business Economics
elasticity. When an increase in income leads to a proportionate change in the
quantity demanded it is unitary elastic ( E1 =1). The elasticity is more than unitary
(E1>1) when an increase in income leads to a more than proportionate change in
quantities demanded. The elasticity is less than unity (E1<1) When an increase in
income leads to a less than proportionate change in quantity demanded.
Uses of Income elasticity in Business Decision:
An understanding of income elasticity is of great significance to business firm for
several reasons.
1. Determine the effect of change in economic activity:
The knowledge of income elasticity is useful in determining the growth
opportunities of the firm. Firms whose demand functions have high income
elasticity will have good growth opportunity in an expanding economy while the
firms facing low income elasticity would neither gain much when the economy
retards.
2. Marketing activity:
The income elasticity can play an important role in marketing activities of a firm. If
per capita or household income is found to be an important determinant of the
demand for a particular product, this can effect the location and nature of sales
outlets. It can also have impact on advertising and promotional activities. In case
of goods having high-income elasticity it is better to make significant promotional
effects due to the potential for substantially increased future business as income
increases.
3. Design marketing strategy:
Knowledge of the income elasticity's can be useful in targeting marketing effects.
Consider a firm specializing in business items. The firm should concentrate its
marketing effects on media that reach the more wealthy segments of the
population because high groups would expect be the prime customers of
business items.
4. Determine the nature of goods:
The concept of income elasticity is useful to determine the nature of goods
whether it is superior or inferior. Positive income elasticity indicates superior
goods whereas negative income elasticity indicates inferior or Giffen goods.
5. Determine sales volume:
The income elasticity for a firm’s product is an important determinant of the firm's
success at different stages of the business cycle. During the periods of expansion
as incomes are rising, firms selling luxury items will find that the demand for their
product will increase at an increasing rate. However during a recession, demand
may decrease rapidly. Conversely, firms producing necessities will not benefit as
much during the period of economic prosperity.
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A Group Assignment on Business Economics
6. Cross elasticity of Demand :
Demand of a product is affected by the price of the related goods. Cross elasticity
of demand measures the degree of responsiveness of the demand of one goods
say x to the change in the price of another goods say y, where x and y may be
complementary or substitutes goods.
Ec =
=
Proportionate change in quantity demanded of x
proportionate change in price of y
change in quantity demanded of x
quantity demanded of x
change in price of y
price of y
Symbolically,
qx
=
py
×
py
qx
The cross elasticity of demand is positive if goods x and y are substitutes,
negative if they are complementary and zero if they are unrelated. The greater
the magnitude of the elasticity, the stranger is the relationship between two goods
and vice- versa.
Uses of cross elasticity in managerial decision:
The concept of cross elasticity is used for many purposes such as:
1. Pricing strategy related to own product:
A firm may produce several related products. For example, Colgate, toothpaste
produces both brush and toothpaste. These goods are complements. Hence
more toothpaste can be sold if the price of toothbrush is reduced. Likewise
Himalayan brewery ltd. produces san Miguel and tiger beer. These goods are
substitutes. If the price of san Miguel is reduced, the demand for tiger beer
declines. In this way, if the firm's products are interrelated, the price of one affects
the demand for other. The knowledge of cross elasticity aids in assessing such
impact and adapting appropriate pricing strategy.
2. Pricing strategy related to other's product:
Several firms in the country produce complementary goods and substitute goods.
The price of one firm affects the demand for other firm's product. If a firm having
many rivals producing substitute goods raise price, it may have to lose the
customers substantially. Hence, an analysis of cross elasticity between own
product and rival's product is essential to design appropriate pricing policy.
3. Classification of goods and markets:
The goods and markets are classified on the basis of elasticity of demand. For
example the goods are classified into substitute goods and Complementary
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A Group Assignment on Business Economics
goods on the basis of cross elasticity of demand. If the cross elasticity between
two goods is positive, these goods are substitutes. On the other hand, if the cross
elasticity is negative, these goods are complementary.
4. Classification of industries.
The cross elasticity is useful in determining the boundaries between industries.
Sometimes problems occurs as to which firm should be included in which
industries. For example, whether the production of car and trucks should be
classified as one industry or two industries. The cross elasticity becomes a basis
of classification in such a situation. The firms having high positive cross elasticity
should be included in one industry. The firms having low or negative cross
elasticity should be included in other industry.
D) Advertising elasticity of demand:
Demand is also affected by advertisement. Advertising elasticity measures the
responsiveness of demand to change in advertisement expenditure. The
advertising elasticity is defined as the percentage change in quantity demanded
of the product resulting from a 1 percent change in advertising expenditure. The
formula for measurement in:
EA = Proportionate change in demand X.
Proportionate change in advertisement expenditure
EA = Change in Demand for X. Demand for X
Change in advertisement expenditure advertisement expenditure
Symbolically,
EA = Dx. × A
A
Dx
Uses of advertisement elasticity in business decision:
1. The concept of advertisement elasticity helps the management in finding out
the effect of advertisement in sales revenue and evaluating the effectiveness
of various media for advertisements purposes.
2. The Advantage of the study of advertising elasticity of demand is that it helps
the management in deciding whether the outlay on advertisement should be
increased or decreased or maintained at present level. If, EA> 1, the
expenditure on its advertisement should be increased. If the EA =1 the outlay
units advertisement should be maintained at present level. If the advertising
elasticity of a commodity is EA<1, the outlay units advertisement should be
maintained at present level. If the advertising elasticity of a commodity is
EA<1, the outlay on its advertisement may be reduced.
3. Study of this concept helps is evaluating the effectiveness of various media of
advertisement also.
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A Group Assignment on Business Economics
4) Forecast the demand of old commodity by taking suitable example.
Several methods are available for forecasting economic variables. The range
from the very naive that requires little effort to very sophisticated ones that is very
costly in terms of time and effort. Some forecasting techniques are basically
qualitative, wile other's are quantitative. Some are based on examining only post
values of the data series to forecast its future based on a great deal of additional
data and relationships. Some are performed by the firm itself, others' are purchased
from consulting firms. In general forecasting techniques can be divided into following
two broad categories.
It is impossible to argue that any one of these forecasting techniques is
superior to others. Each method has its strengths and weakness. The best forecast
methodology for a particular task depends on the nature of the specific forecasting
problem. Therefore choice of technique depends upon a number of important
factors. The important factors must be considered for appropriate methodology aredistance into the future, the lead time available for making decisions, the level of
accuracy required, and the quality of data available for analysis, deterministic nature
of forecast relations and the cost and benefits associated with the forecasting
problems.
The following factors should be taken into account before to have an efficient
forecast of demand.
a) Identification of objectives:
It is the first step of business forecasting. It is necessary to identify and clearly
state the objective of the forecasting. The objective of the forecasting may be
short term or long term. Similarly it may be required for market share forecasts or
for industry as a whole. The approach needed may be different for different
activities.
b) Ascertaining the demand determinates and probable relationship with
demand:
The second step of business demand forecasting is to find the determinants of
the business demand and its relationship with demand. We can express the
relationship between quantity demanded and its determinants as:
Dx = f (Px, Y, Pi, t, Ad, E, Lt, Pop, Yt-1)
Where,
Px
Y
Pi
T
Ad
E
Lt
Pop
Yt-1
=
=
=
=
=
=
=
=
=
Price of the product
Income of the consumer
Price of the Related goods.
Taste, preference of the consumer
Advertisement
Expectation
Liquidity Preference
Population
Post level of Income
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A Group Assignment on Business Economics
The factors influencing the demand differ widely depending upon the nature of the
product under consideration such as consumer's durable goods, consumer's non
durable goods and capital goods. After ascertaining the demand determinants, the
probable method of forecasting can be selected and used for business forecasts.
There are mainly two methods in the business forecasting. The first in survey
method and the second is statistical method. For forecasting demand for old product,
statistical method is the best because we have the historical and cross section data
of that particular product.
Statistical methods of demand forecasting include the following techniques in
managerial economics;
1) Trend projection / Time series Analysis
2) Barometric Method
3) Regression Analysis
The above methods are used to forecast the demand for old product. But
have we are explaining the regression analysis method of demand forecasting in
detail.
Regression Analysis
The literal meaning of the word "Regression" is stepping or returning back to the
average values. The term was first developed by Sir Francis Galeton in 1877.
Regression is the statistical tool which is used to determine the statistical relationship
between two or more variables and to make estimation or prediction of one variable
on the basis of other variables. In other words, regression is that statistical tool with
the help of which the unknown value of one variable can be estimated or predicted
on the basis of known value of the variable. Assuming that the two variables are
clearly related, we can estimate the value of one variable form the given value of
another. For example, if we know that production and sales are closely related we
can find out the quantity of production required to achieve a given amount of sales.
Thus regression determines the average probable change in one variable based on
to certain amount of change in another. The variable whose value is given is called
“Independent Variable” and the variable whose value is to be predicted is called
“Dependent Variable”. The analysis is used to describe the average mathematical
relationship between two variables is called simple linear regression analysis. The
word 'SIMPLE' is used because there is only one independent variable and 'Linear'
is used because the relationship between the independent and dependent variable is
assumed to be linear. The term linear means that an equation of straight line of the
form is:
Y= a + bx
Where,
Y = Dependent variable
X = Independent variable
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A Group Assignment on Business Economics
1. Regression line (equation) of Y on X
Let Y = a + bx ……………………….. (1)
Denotes the regression equation of Y on X .for a set of n pairs where a, b are
constants.( a is the minimum value of Y when X = 0 and b is the regression coefficient of Y on X or rate of change in Y for unit change in x), and are estimated
by solving following two normal equations.
y = na + bx
xy = ax + bx2
Finally substituting the values of a and b in equation (1) required fitted
(estimated) regression equation of Y on X is obtained Y.
Ŷ=â+bx
For given value of x, the probable value of Y can be predicted. (estimated)
2. Regression line (equation) of X on Y :
Where X is considered as dependent variable then the regression equation of X
on Y of a Set of n observation can be formed by
x = a' + b' y
Where a', b' are constant (or a' is the minimum value of X when Y= o and b' is the
regression co-efficient of X on y or rate of change in X for unit change in Y).
The values of a', b' can be estimated by solving following normal equations.
X = na' + b'y
xy = a' y + y2
Finally substituting the values of a and b in equation (ii) the required estimated
(fitted) regression equation of X on Y is obtained by
x=a +by
For given y the value of x can be predicted (estimated). For more than two
variables, multiple regression analysis is used.
x = na + bx
xy = ax+bx2
22
A Group Assignment on Business Economics
An example of Regression analysis for forecasting the demand of the old
commodity is shown below with suitable solved problem. The following solved
problem has three variables; Two Independent Variables – Advertisement and Price
and One Dependent variable – Sales.
#
Abhishek, owner and general manager of the Abhishek and Rajkumar Co.,
dealing with campus stationary store, is concerned about the sales behavior of
compact cassette tape recorder sold at the store. He realizes that there are many
factors that might help explain sales, but believes that advertising and price are
major determinants. Abhishek has collected the following data.
Sales (Unit Sold)
Advertising (No. of Ads)
Price ($)
33
3
125
61
6
115
70
10
140
82
13
130
17
9
145
24
6
140
a) Calculate least squares equation to predict sales from advertising and price.
b) If advertising is 7 and price is $132, what sales would be predicted?
Solution:
a) Calculation of least squares equation to predict sales from advertising and price.
Let, Sales (in unit) be y and Advertising (on of Ads) and price ($) be x1 and x2 respectively.
Table of Calculation
Sales (y)
33
61
70
82
17
24
287
Ads (x)
3
6
10
13
9
6
47
Price (x2)
125
115
140
130
145
140
795
yx1
99
366
700
1066
153
144
2528
yx2
4125
7015
9800
10660
2465
3360
37425
X12
9
36
100
169
81
36
431
x1y1
375
690
1400
1690
1305
840
6300
X22
15625
13225
19600
16900
21025
19600
105975
Here, Total no. of experiment = (N) = 6
Now, The least square regression of sales(y) on advertisement(x1) and price (x2) is given by –
Y Y = a + b1x1 + b2x2
2 ………………………………. eq
(i)
(i) Taking summation sign on both sides of eq (i)
i.e . y = Na + b1x2 + b2x2
257 = 6a + 47b1 + 795b2
or, 6a + 47b1 + 795b2 = 287…………………………… eq (ii)
(ii) Multiplying eq (i) by x1 and then taking summation on both sides,
i.e. yx1 = ax1 + b1x12 + b2x1x2
2528 = 47a + 431b1 + 6300b2
or, 47a + 431b1 + 6300b2 = 2528 …………………….. eq (iii)
Similarly,
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A Group Assignment on Business Economics
(iii) Multiplying eq (i) by x2 and then taking summation on both sides.
i.e. yx2 = ax2 + b1x1x2 + b2x22
37425 = 795a + 6300b1 + 105975b2
or, 795a + 6300b1 + 105975b2 = 37425 ………………. eq (iv)
Now, solving eq (ii), eq (iii) and eq (iv) for a1b1 and b2 using crammers rule
The coefficient of eq = ∆ =
6
47
795
47
431
6300
47
795
6300
105975
795
6300
105975
Expanding along with R1,
∆ = 6 431
6300
6300
105975
- 47
+ 795
47
795
431
6300
= 6(431 + 105975 - (6300)2 ) – 47 (47 x 105975 – 6300 x 795) + 795(47 x 6300 – 431 x 795)
= 6 x 5985225 – 47 x ( -27675) + 795 x (- 46545)
= 35911350 + 1300725 – 37003275
= 209800
∆1 =
287
47
2528 431
37425 6300
= 287 431
6300
795
6300
105975
6300
105975
- 47
2528 6300
37425 105975
+ 795
2528 431
37425 6300
+795
47
795
= 287 x 5985225 – 47 x ( -32127300) + 795 x (-203775)
= 171775975 – 1509983100 – 162001125
= 45775350
Again,
∆2 =
6
47
795
287
795
2528 6300
37425 105975
= 6
431 6300
-287 47
6300
37425 105975
795
105975
= 6 x 32127300 – 287 x ( -27675) + 795 x (-250785)
= 192763800 – 7942725 – 199374075
= 1332450
24
2528
37425
A Group Assignment on Business Economics
Similarly,
∆3 =
6
47
795
47
431
6300
= 6
431
6300
6300
37425
287
2528
37425
-287
47
795
2528
37425
+795
47
795
431
6300
= 6 x 203775 – 47 x ( -250785) + 287 x (- 46545)
= 1222650 + 11786895 – 13358415
= -348870
 a1 = ∆1/∆ = 45775350/28800 = 219.2306
 b1 = ∆2/∆ = 1332450/208800 = 603815
 b2 = ∆2/∆ = -348870/20880 = - 1.6708
Now, substituting the value of a, b1 and b2 in the eq (i) i.e. y = a+ b1x1 + b2x2
y = 219.23 + 6.32x1 + ( - 1.67 ) x2
or, y = 219.23 + 6.32x1 - 1.67 x2
 The required least square equation to predict sales from advertising and price is:
y = 219.23 + 6.38 x1 – 1.67x2
b) If advertising is 7 and price is $132, what sales would be predicted?
Here,
No. of advertisement ( x1 ) = 7
Price ( x2 ) = $ 132
Sales can be estimated from above estimation equation, so substituting values of 7
Ads and Price $ 32
ŷ = 219.23 + 6.38 x 7 – 1.67 x 132
ŷ = 219.23 + 44.66 – 220.44
ŷ = 43.45
 The predicted sales when Ads = 7 and price ($) = 32 is 43.45  44
25