Unit 1:- Managerial Economics:

Sl No Contents Page
1.1 Meaning, Scope and Significance 2-6
1.2 Uses of Managerial Economics 6-7
1.3 Objectives and alternative Hypothesis of the firm 7 - 15
1.4 Law of demand 15- 16
1.5 Exceptions to Law of demand 16 - 19
1.6 Elasticity of demand – Price, Income, Cross and 19 - 31
advertising Elasticity
1.7 Uses of Elasticity of Demand for decision making 31 - 33
1.8 Demand Forecasting: Meaning and significance 33 - 42
(Problems on Elasticity of demand only)

Unit – 1
INTRODUCTION TO MANAGERIAL ECONOMICS
Prepared By Dr Virupaksha Goud
1.1.1 MEANING
Managerial Economics is another branch in the science of economics. Sometimes it is
interchangeably used with business economics. Managerial economics is concerned with
decision making at the level of firm. It has been described as an economics applied to decision
making. It is viewed as a special branch of economics bridging the gap between pure economic
theory and managerial practices. It is defined as application of economic theory and
methodology to decision making process by the management of the business firms. In it,
economic theories and concepts are used to solve practical business problem. It lies on the
borderline of economic and management. It helps in decision making under uncertainty and
improves effectiveness of the organization. The basic purpose of managerial economic is to show
how economic analysis can be used in formulating business plans.
Managerial economics is a science that deals with the application of various economic
theories, principles, concepts and techniques to business management in order to solve
business and management problems. It deals with the practical application of economic

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theory and methodology to decision-making problems faced by private, public and non-
profit making organizations.
The same idea has been expressed by Spencer and Seigelman in the following words.
“Managerial Economics is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by the management”. According to
Mc Nair and Meriam, “Managerial economics is the use of economic modes of thought to
analyze business situation”. Brighman and Pappas define managerial economics as,” the
application of economic theory and methodology to business administration practice”. Joel dean
is of the opinion that use of economic analysis in formulating business and management policies
is known as managerial economics.

Objectives of Managerial Economics : The basic objective of managerial economics is to analyze

the economic problems faced by the business. The other objectives are:

1. To integrate economic theory with business practice.

2. To apply economic concepts and principles to solve business problems.
3. To allocate the scares resources in the optimal manner.
4. To make all-round development of a firm.
5. To minimize risk and uncertainty
6. To helps in demand and sales forecasting.
7. To help in profit maximization.
8. To help to achieve the other objectives of the firm like industry leadership, expansion
implementation of policies etc...
Managerial Economics assist in solving the three major questions of Organization:
These questions are:

• What to produce?
• How to produce?
• For whom to produce?

What to Produce?
The first question every society faces is what to produce. Should a society build more roads or
schools? Because of scarcity, society cannot build everything it wants. Choices have to be made.
Once a society determines what to produce it then needs to decide how much should be
produced. In a market economy the "what" question is answered in large part by the demand of
consumers?

How to Produce?
The next question a society needs to decide after what to produce is how to produce the desired
goods and services. Each society must combine available technology with scarce resources to
produce desired goods and services. The education and skill levels of the citizens of a society
will determine what methods can be used to produce goods and services. For example, does a
nation possess the technology and skills to pick grapes with a mechanized harvester, or does it
have to pick the grapes by hand?

Whom to produce?

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The final question each society needs to ask is for whom to produce. Who is to receive and
consume the goods and services produced? Some workers have higher incomes than others. This
means more goods and services in a society will be consumed by these wealthy individuals, and
less by the poor. Different groups will benefit from the different ways that we choose to spend
our money.
Features of managerial Economics

1. It is a new discipline and of recent origin

2. It is a highly specialized and separate branch by itself.

3. It is basically a branch of microeconomics and as such it studies the problems of firm in

detail.

4. It is mainly a normative science

5. It is more realistic, pragmatic and highlights on practical application of various economic

concepts

Factors of Production: It refers to the resources used to produce goods and services in a society.
Economists divide these resources into the four categories described below.
• Land refers to all natural resources. Such things as the physical land itself, water, soil, timber
are all examples of land. The economic return on land is called rent. For example, a person
could own land and rent it to a farmer who could use it to grow crops. A second resource is labor.
• Labor refers to the human effort to produce goods and services. The economic return on labor
is called wages. Anyone who has worked for a business and collected a paycheck for the work
done understands wages. A third factor of production is capital.
• Capital is anything that is produced in order to increase productivity in the future. Tools,
machines and factories can be used to produce other goods. The field of economics differs from
the field of finance and does not consider money to be capital. The economic return on capital is
called interest.

Finally, the fourth factor of production is called entrepreneurship. Entrepreneurship refers to

the management skills, or the personal initiative used to combine resources in productive ways.
Entrepreneurship involves the taking of risks. The economic return on entrepreneurship is profits

Tools of Managerial Economics

 It is a science of decision-making. It concentrates on decision-making process, decision-
o Models and decision variables and their relationships.
 It is both conceptual and metrical and it helps the decision-maker by providing
measurement of various economic variables and their interrelationships.
 It uses various macro-economic concepts like national income, inflation, deflation, trade
cycles etc to understand and adjust its policies to the environment in which the firm
operates.

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  It also gives importance to the study of non-economic variables having implications of
economic performance of the firm. For example, impact of technology, environmental
forces, socio-political and cultural factors etc.
 It uses the services of many other sister sciences like mathematics, statistics, engineering,
accounting, operation research and psychology etc to find solutions to business and
management problems.

1.1.2 SCOPE OF MANAGERIAL ECONOMICS

Scope is something which tells us how far a particular subject will go. As far as Managerial
Economic is concerned it is very wide in scope. It takes into account of almost all the problems
and areas of manager and the firm. Managerial economics deals with the Demand analysis,
Forecasting, Production function, Cost analysis, Inventory Management, Advertising, Pricing
System, Resource allocation etc. Following aspects are to be taken into account while knowing
the scope of managerial economics:

Demand Analysis and Forecasting: Unless and until knowing the demand for a product how
can we think of producing that product. Therefore demand analysis is something which is
necessary for the production function to happen. Demand analysis helps in analyzing the various
types of demand which enables the manager to arrive at reasonable estimates of demand for
product of his company. Managers not only assess the current demand but he has to take into
account the future demand also.

Production Function: Conversion of inputs into outputs is known as production function. With
limited resources we have to make the alternative use of this limited resource. Factor of
production called as inputs is combined in a particular way to get the maximum output. When the
price of input rises the firm is forced to work out a combination of inputs to ensure the least cost
combination.

Cost analysis: Cost analysis is helpful in understanding the cost of a particular product. It takes
into account all the costs incurred while producing a particular product. Under cost analysis we
will take into account determinants of costs, method of estimating costs, the relationship between
cost and output, the forecast of the cost, profit, these terms are very vital to any firm or business.

Inventory Management: What do you mean by the term inventory? Well the actual meaning of
the term inventory is stock. It refers to stock of raw materials which a firm keeps. Now here the
question arises how much of the inventory is ideal stock. Both the high inventory and low
inventory is not good for the firm. Managerial economics will use such methods as ABC
Analysis, simple simulation exercises, and some mathematical models, to minimize inventory
cost. It also helps in inventory controlling.

Advertising: Advertising is a promotional activity. In advertising while the copy, illustrations,

etc., are the responsibility of those who get it ready for the press, the problem of cost, the
methods of determining the total advertisement costs and budget, the measuring of the economic
effects of advertising are the problems of the manager. There’s a vast difference between
producing a product and marketing it. It is through advertising only that the message about the

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product should reach the consumer before he thinks to buy it. Advertising forms the integral part
of decision making and forward planning.

Pricing system: Here pricing refers to the pricing of a product. As you all know that pricing
system as a concept was developed by economics and it is widely used in managerial economics.
Pricing is also one of the central functions of an enterprise. While pricing commodity the cost of
production has to be taken into account, but a complete knowledge of the price system is quite
essential to determine the price. It is also important to understand how product has to be priced
under different kinds of competition, for different markets. Pricing equals cost plus pricing and
the policies of the enterprise. Now it is clear that the price system touches the several aspects of
managerial economics and helps managers to take valid and profitable decisions.

Resource allocation: Resources are allocated according to the needs only to achieve the level of
optimization. As we all know that we have scarce resources, and unlimited needs. We have to
make the alternate use of the available resources.

For the allocation of the resources various advanced tools such as linear programming are used
to arrive at the best course of action.

Nature of Managerial Economics: Managerial economics aims at providing help in decision

making by firms. It is heavily dependent on microeconomic theory. The various concepts of
micro economics used frequently in managerial economics include Elasticity of demand;
Marginal cost; Marginal revenue and Market structures and their significance in pricing policies.
Macro economy is used to identify the level of demand at some future point in time, based on the
relationship between the level of national income and the demand for a particular product. It is
the level of national income only that the level of various products depends. In managerial
economics macroeconomics indicates the relationship between

(a) The magnitude of investment and the level of national income,

(b) The level of national income and the level of employment,
(c) The level of consumption and the level of national income.

In managerial economics emphasis is laid on those prepositions which are likely to be useful to
management.

1.2 USES OR BENEFITS OF MANAGERIAL ECONOMICS

The following are the uses or benefits of study of managerial Economics.

1. It gives guidance for identification of key variables in decision-making process.

2. It helps the business executives to understand the various intricacies of business and
managerial problems and to take right decision at the right time.

3. It provides the necessary conceptual, technical skills, toolbox of analysis and techniques
of thinking and other such most modern tools and instruments like elasticity of demand

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 and supply, cost and revenue, income and expenditure, profit and volume of production
etc to solve various business problems.

4. It is both a science and an art. In the context of globalization, privatization, liberalization

and marketization and a highly competitive dynamic economy, it helps in identifying
various business and managerial problems, their causes and consequence, and suggests
various policies and programs to overcome them.

5. It helps the business executives to become much more responsive, realistic and
competent to face the ever changing challenges in the modern business world.

6. It helps in the optimum use of scarce resources of a firm to maximize its profits.

7. It also helps in achieving other objectives a firm like attaining industry leadership, market
share expansion and social responsibilities etc.

8. It helps a firm in forecasting the most important economic variables like demand, supply,
cost, revenue, price, sales and profit etc and formulate sound business polices

9. It also helps in understanding the various external factors and forces which affect the
decision-making of a firm.
Thus, it has become a highly useful and practical discipline in recent years to analyze and
find solutions to various kinds of problems in a systematic and rational manner.
Knowledge of decision making and forward planning
Managerial Economist is a specialist and an expert in analyzing and finding answers to business
and managerial problems. A Managerial Economist has to perform several functions in an
organization. Among them, decision-making and forward planning are described as the two
major functions and all other functions are derived from these two basic functions.
1. Decision-making
The word ‘decision’ suggests a deliberate choice made out of several possible alternative
courses of action after carefully considering them. Decision-making is essentially a process
of selecting the best out of many alternative opportunities or courses of action that are open
to a management.
2. Forward planning
The term ‘planning’ implies a consciously directed activity with certain predetermined
goals and means to carry them out. It is a deliberate activity. It is a programmed action.
Basically planning is concerned with tackling future situations in a systematic manner.
Forward planning implies planning in advance for the future. It is associated with
deciding the future course of action of a firm. It is prepared on the basis of past and current
experience of a firm.
1.3 OBJECTIVES AND ALTERNATIVE HYPOTHESIS OF THE FIRM

Important objectives other than profit maximization are:

1. Profit Maximization Approach
2. Maximization of sales revenue,
3. Sales maximization goal

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 4. Maximization of the firm’s growth rate,
5. Entry prevention and risk avoidance
6. Satisfying behavior
7. Operational goals of business firms
8. Market Share Goals
9. Long Term Survival:

1. Profit Maximization Approach:

Profit maximization approach about the behavior of the firm is one of the most fundamental
assumptions of traditional neo-classical economic theory. The attempt of the entrepreneur to
maximize profit is regarded as the rational behavior of the entrepreneur. Just as the rational
behavior in the case of firms is profit maximization, profit is basic to the philosophy of the free
enterprise system. Adam Smith saw profit as the device which transforms the selfishness of
mankind into channels of useful service.

2. S a l e s r e v e n u e M a x i m i z a t i o n
Baumol has postulated maximization of sales revenue as the alternative to profit
maximization objective. The reason between these objectives is the dichotomy
between ownership and management in large business corporations. This dichotomy gives the
managers an opportunity to set their goals other than profit maximization goal which most owner
businessmen pursue. Given the opportunity, the mangers choose to maximize their own utility
function. According to Baumol, the most plausible facto in manager’s utility function is
maximization of the sales revenue. The factors which explain the pursuance of this goal by
managers are the following:

First, Salary and other earnings of managers are more closely related to sales revenue than to
profits.
Second, Banks and financial corporations look at sales revenue while financing the corporations.
Third, Trend in sales revenue is readily available indicator of the performance of the firm .It
helps also in handling the personnel problem.
Fourth, increasing sales revenue increases the prestige of the managers while profit goes to the
owners.
Fifth, The managers find profit maximization a difficult objective to fulfil consistently over time
and at the same level. Profits may fluctuate with changing conditions.
Finally, Growing sales strengthen competitive spirit of the firm i n the market and vice versa.

3. Sales maximization Goal

The sales department generally keeps a target and every year it tries to achieve the target.
Sometimes, the sales department tries to push the sales beyond the target and as a consequence
the firm tries to increase its output. A stage comes when the output is optimum and that the
profits are at their maximum. If a firm produces beyond this level, it incurs losses. The first
stage, that is, when the profits increase, with an increase in output, in known as increasing
returns the level of output at which profits are maximum is known as constant returns when the
output is increased beyond a certain point, resulting a decline in profits, the process of decreasing
returns sets in. In the language of Managerial Economics, we say that is the sales department

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pushes sales beyond the point of constant returns, diminishing returns sets in. Sales therefore
should not be pushed beyond the profit maximizing point.

4. Maximization Of Firms Growth Rate

According to Robin Morris, managers try to maximize the firm’s Balanced Growth Rate subject
to managerial and financial constraints. A firms growth rate is balanced when the demand for its
products and the supply of capital to the firm increase at the same rate. The two growth rates are
translated two utility functions: (i) Manager’s Utility Function and (ii) Owner’s Utility Function.
Managers try to achieve both the above objectives so as to maximize firms Balanced Growth
Rate. The Manager’s Utility Function and The Owner’s Utility Function can be specified as
follows:

Manager’s Utility Function: Um = ƒ(salary power, job security, prestige and status)
Owner’s Utility Function Uo = ƒ(output, capital, market share, profit and public esteem)

According to Morris, by maximizing these two variables, the managers maximize their own
utility function and the owner’s utility function. Maximization of these two variables depends
upon the maximization of the growth rate of the firm.

5. Entry Prevention and Risk Avoidance

Yet another alternative objective of the firms suggested by some economists is to prevent entry
of new firms into the industry. The motive behind entry prevention may be (a) profit
maximization in the long run, (b) securing constant market share and (c) avoidance of risk
caused by unpredictable behavior of the new firms.

6. Satisfying Behavior
Managers work under conditions of uncertainty and various constraints. Under such conditions,
it is not possible for firms to effectively pursue the processes required to maximize profits.
Instead they seek to achieve a “Satisfactory Profit”, a “Satisfactory Growth” and so on. This
behavior of firms is termed as Satisfactory Behavior.

Apart from dealing with the uncertain business world, managers will have to satisfy a variety of
groups of people – managerial staff, labor, shareholders, customers, financiers, input suppliers
accountants, lawyers, authorities, etc. All these groups have their interests in the firms – often
conflicting. The manager’s responsibility is to “satisfy” them all. This “Satisfying Behavior”
implies satisfying various interest groups by sacrificing the firm’s interests or objectives.

In order to reconcile between the conflicting interests and goals, the managers form an
aspirational level of the firm combining the following goals: (a) Production goal (b) Sales and
market share goals (c) Inventory goal and (d) Profit goal.

7. Operational goals of business firms

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All business firms have undoubtedly some organizational goals to pursue. Organizational goals
are of five kinds, namely, he production goal, the inventory goal, the sales goal, the market share
goal and the profit goal.

Production Goal
The production department is responsible for production of commodities. The production
department prepares a plan of production, which has two aspects. First, how much to produce?
(that is the volume of production).

In how many days will the target volume be produced (this is the time period).The production
targets is the outcome orders booked by the marketing department. The marketing department
sends its requisition to the production department indicating the quantity required and the time
period within which the quantity is required. To keep up both the volume of production and
deadline, the production department plans its production schedule. The problems faced by the
production department are

(a) Availability of labour/manpower

(b) Availability of raw materials
(c) Breakdown in the plant
(d) Machines going out of order `
(e) Power failures

Inventory Goals
Inventory could mean stock of raw materials, stock of spare parts and stock of finished goods.
Inventory is expressed in terms its monetary value; that is in terms of costs. The cost of holding
stocks include

(a)Investment of capital in purchase of raw materials, spare parts, etc.

(b)Interest on capital
(c)The stocks have to be stored involving rent for godown
(d)Administrative expenses like engaging a watchman

For All these expenses have to be incurred and these are known as inventory costs. Therefore the
higher the level of stocks to be maintained, the higher the cost of maintaining them. This is
known as cost of holding stocks.

Then there is the cost of what is known as stock-out. If the stock-out situation happens in the
case of raw materials, it could cause a interruption in the flow of production and thereby reduce
the availability of the product to the customers. This will lead to a loss of goodwill in the market
and would lead to a loss of customers. So a balance has to be struck between high inventory and
the resultant inventory carrying costs and minimum inventory to avoid stock out situations and
the accompanying loss. These can be done by several inventory control methods and inventory
management.

8. Market Share Goals

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It refers to a share of a company’s sales of a particular product in the total sales of that product of
all the companies. For example; there are several brands of toothpaste a in the market. In a
particular month, the total sales of tooth pastes on an all-India basis are estimated. Then the sales
of the Company’s toothpaste in the particular month are ascertained. These sales are expressed as
a percentage of the total sales of all the toothpastes. This percentage is known as the market
share of the total sales of all the toothpastes. This percentage is known as the market share of that
company. Every company constantly strives to increase its market share. Therefore, the goal of
market share is linked with the goals of those persons in a firm who are interested in increasing
the market share, so that their company may occupy a better position in the market than its
competitors.

9. Long Term Survival:

According to Rothschild, main objective of a firm is to obtain the stage of long-run survival. A
firm having this aim is always reviewed cautiously and all of its decisions are safety-oriented.
Such firms do not like to reap larger profits in short-run but prefer lower profits in the long-run.

Theories of the Firm

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MANAGERIAL THEORIES OF THE FIRM

Managerial theories of the firm place emphasis on various incentive mechanisms in explaining the
behavior of managers and the implications of this conduct for their companies and the wider economy.

According to traditional theories, the firm is controlled by its owners and thus wishes to maximize short
run profits. The more contemporary managerial theories of the firm examine the possibility that the firm is
controlled not by its owners, but by its managers, and therefore does not aim to maximize profits.
Although profit plays an important role in these theories as well, it is no longer seen as the sole or
dominating goal of the firm. The other possible aims might be sales revenue maximization or growth.

Economics Theories

 Baumol's Theory of Sales Revenue Maximisation

 Marris Growth Maximization Model
 Williamson’s Managerial Discretionary Theory
Baumol's Theory of Sales Revenue Maximisation
Prof. Baumol, in his book 'Business behaviour, Value and Growth' has propounded a theory of Sales
Maximisation. Main aim of a firm is to maximise sales. By sales he meant total revenue earned by
the sale of goods. That is why this goal is also referred to as Sales Maximisation Goal. According to
this theory, once profits reach acceptable levels, the goal of the firms become maximisation of sales
revenue rather than maximisation of profits.

In the words of Baumoul, 'The sales maximisation goal says that managers of firms seek to maximise
their sales revenue subject to the constraint of earning a satisfactory profits. "

The above definition maintains that when the profits of firms reach a level considered satisfactory by
the shareholders then the efforts of the managers are directed to maximise revenue by promoting
sales instead of maximising profit. While studying this theory. K must be kept in view that firms do
not Ignore profit altogether. They do aspire to attain a general level of profit. But once an acceptable
level of profit is obtained their goal shifts to sales maximisation in place of profit maximisation.

Baumol raised serious questions on the validity of profit maximisation as an objective of the firm. He
stressed that in competitive markets, firms would rather aim at maximising revenue, through
maximisation of sales. According to him, sales volumes, and not profit volumes, determine market
leadership in competition. He further stressed that in large organisations, management is separate
from owners. Hence there would always be a dichotomy of managers' goals and owners' goals.
Manager's salary and other benefits are largely linked with sales volumes, rather than profits.

Baumol hypothesised that managers often attach their personal prestige to the company's revenue or
sales; therefore they would rather attempt to maximise the firm's total revenue, instead of profits.
Moreover, sales volumes are better indicator of firm's position in the market, and growing sales
strengthen the competitive spirit of the firm. Since operations of the firm are in the hands of
managers, and managers' performance is measured in terms of achieving sales targets, therefore it
follows that management is more interested in maximising sales, with a constraint of minimum
profit. Hence the objective is not to maximise profit, but to maximise sales revenue, along with

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which, firms need to maintain a minimum level of profit to keep shareholder satisfied. This minimum
level of profit is regarded as the profit constraint.

However, empirical evidence to support above arguments of Baumol is not sufficient to draw any
definite conclusion. Whatever research has been done is based on inadequate data; hence the results
are inconclusive.

Following arguments are given in favour of maximisation of sales goal:

i. More Realistic: Goal of maximisation of sales is a more realistic goal- In fact, firms accord more
importance to the goal of sales maximisation than profit maximisation. It is so because success of a
firm is generally judged from its total sales. According to Ferguson and Krupps, 'Among the various
alternatives advanced, Baumoul’s thesis has great advantage — it raises the other models in the
direction of reality and plausibility while still permitting a rather general theoretical analysis."

ii. More Practical: Revenue maximisation thesis of Baumol is more practical. It is so because goal of
revenue (Sales) maximisation leads to more production which, in turn, leads to fall in price. As a
result, consumers' welfare is promoted. They also endorse this goal of the firms.

iii. More Availability of Loans: At the time of sanctioning loan to a firm, financial institutions mainly
consider its sales. Prospects of loans are bright for such firms as have large total sales.

iv. Strong Position in the Market: Maximum sales of a firm symbolize its strong position in the
market. Sales of a firm will be large only in that situation when consumers like its production, firm
has more competitive power and has been expanding. All these features are indicative of the progress
of the firm.

v. More Advantageous to the Managers: It is more to the advantage of the managers that the firm
should aim at sates maximisation. This way their credibility enhances in the market. Maximum sales
is a reflection of the competence of the managers It has a favorable effect on their wages. Firm is in a
position to offer higher wages to the employees. Consequently, employer-employee relations become
more cordial. II is the constant endeavour of the managers to maximize the sales of the firm after
attaining a given level of profit.

Marris Growth Maximization Model:

Working on the principle of segregation of managers from owners, Marris proposed that owners
(shareholders) aim at profits and market share, whereas managers aim at better salary, job
security and growth. These two sets of goals can be achieved by maximising balanced growth of
the firm (G), which is dependent on ihe growth rate of demand for the firm's products (GD) and
growth rate of capital supply to the firm (GC). Hence growth rate of the firm is balanced when
the demand for its product and the capital supply to the firm grow at the same rate.

Marris further said that firms face two constraints in the objective of maximisation of balanced
growth, which are explained below:

i. Managerial Constraint
Among managerial constraints, Marris stressed on the importance of the role of human resource
in achieving organisational objectives. According to him, skills, expertise, efficiency and

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sincerity of team managers are vital to the growth of the firm. Non availability of managerial
skill sets in required size creates constraints for growth: organisations on their high levels of
growth may face constraint of skill ceiling among the existing employees. New recruitments may
be used to increase the size of the managerial pool with desired skills; however new recruits lack
experience to make quick decisions, which may pose as another constraint.

ii. Financial Constraint

This relates to the prudence needed in managing financial resources. Marris suggested that a
prudent financial policy will be based on at least three financial ratios, which in turn set the limit
for the growth of the firm. In order to prove their discretion managers will normally create a
tradeoff and prefer a moderate debt equity ratio (rj), moderate liquidity ratio (r2) and moderate
retained profit ratio (r3). (Let us mention here that the ratios used in the financial constraint are
dealt with in detail in any standard text book on Financial Management and are beyond the scope
of this book). However a brief description is given hereunder:

(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners* capital. High
value of debt equity ratio may cause insolvency; hence a low value of this ratio is usually
preferred by managers to avoid insolvency. However, a low value of r, may create a constraint to
the growth of the firm in terms of dependence on high cost capital, i.e., equity.

(b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities and is an
indicator of coverage provided by current assets to current liabilities. According to Marris, a
manager would try to operate in a region where there is sufficient liquidity and safety and hence
would prefer a high liquidity ratio. But a high r2 would imply low yielding assets, since liquid
assets either do not earn at all (like cash and inventory), or earn low returns (like short term
securities).

(c) Retention ratio (r3) This is the ratio between retained profits and total profits. In other words,
it is the inverse of dividend payout ratio, i.e., the retained profits are that portion of net profit
which is not distributed among shareholders. A high retention ratio is good for growth, as
retained profits provide internal source of funds. However, a higher r3 would imply greater
volume of retained profits, which may antagonise the shareholders. Hence managers cannot
afford to keep a very high value of retention ratio.

Williamson’s Managerial Discretionary Theory:

The theory of Managerial Utility Maximisation was developed separately by Berle-Means-

Galbralth and Williamson. It is also known as Managerial Discretion Theory. The Theory is
based on the concept that shareholders or owners of the firm and managers are (two separate
groups. The owners or the shareholders want high dividends and are. therefore, interested In
maximising profits, the managers, on the other hand, have different motives other than profit
maximisation. Once the managers have achieved a level of profit that will pay satisfactory
dividends to shareholders and still ensure growth.

they are free to increase their own emoluments and also the size of their staff and expenditure on
them. In the words of Williamson, "7b the extent that the pressure from the capital market and

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competition in the product market is imperfect, the manager, therefore, has discretion to pursue
goals other than profits." Further Berle and Means suggested that "The lack of corporate
democracy leaues owners or shareholders with little or no power to change corporation policy."

According to Williamson, "Managerial Utility function may be expressed as follows:

U = f(S, M. ID)

It will be read: Managerial utility is a function (f) of additional expenditure on staff, managerial
emoluments and discretionary investment.

(Here, U = managerial utility; S = additional expenditure on staff; M = managerial emoluments

and ID = discretionary investment).

Managerial utility function maximises the utility of the managers rather than profits of the firm.
The manager is expected to follow policies which maximise the following components of his
utility function.

i. Expansion of Staff: The manager will like to increase the quality and number of staff reporting
to him. This will lead to an increase in the salary of the staff. More staff are valued because they
lead to the manager getting more salary, more prestige and more security.

ii. Increase in Managerial Emoluments: Managerial Utility also depends on managerial

emoluments. It includes facilities like entertainment allowance, luxurious office, staff car,
company phone, etc. Expenditure of this nature reflects to a large extent the prestige, power and
status of the manager.

iii. Discretionary Power of Investment: Managerial utility also depends on the discretion of the
manager to undertake investment beyond those required for normal operations. The manager is
in a position to invest in advanced technology and modem plants. Such investments may or may
not be economically efficient. These investments may be undertaken for the self-satisfaction of
the manager.

According to the theory, in a firm, shareholders and managers are two separate groups. The firm
tries to get maximum returns on investment and get maximum profit, whereas managers try to
maximize profit in their satisfying function.

At last, Williamson’s managerial discretion theory shows the utility function of a manager. In this
theory, the firm will try to get maximum returns or maximum profit where as manager try to
maximum utility satisfying function. They are in equilibrium when the utility has maximum
amount.

1.4 DEMAND ANALYSIS

Understand the concept of demand and its features.
The term demand is different from desire, want, will or wish. In the language of economics,
demand has different meaning. Any want or desire will not constitute demand

14
Demand = Desire to buy
+ Ability to pay
+ Willingness to pay
The term demand refers to total or given quantity of a commodity or a service that are
purchased by the consumer in the market at a particular price and at a particular time
The following are some of the important qualifications of demand-

 It is backed up by adequate purchasing power.

 It is always at a price.

 It should always be expressed in terms of specific quantity

 It is created in the market.

 It is related to a person, place and time.

Consumers create demand. Demand basically depends on utility of a product. There is a direct
relation between the two i.e., higher the utility, higher would be demand and lower the utility,
lower would be the demand.
Demand Curve
A demand curve is a locus of points showing various alternative price – quantity combinations.
In short, the graphical presentation of the demand schedule is called as a demand curve.
It represents the functional relationship between quantity demanded and prices of a given
commodity. The demand curve has a negative slope or it slope downwards to the right. The
negative slope of the demand curve clearly indicates that quantity demanded goes on increasing
as price falls and vice versa.
The Law of Demand
“Other things being equal, a fall in price leads to expansion in demand and a rise in price
leads to contraction in demand”.
Important Features of Law of Demand
1. There is an inverse relationship between price and demand.
2. Price is an independent variable and demand is a dependent variable
3. It is only a qualitative statement and as such it does not indicate quantitative changes in price
and demand.
4. Generally, the demand curve slopes downwards from left to right.
The operation of the law is conditioned by the phrase “Other things being equal”. It indicates
that given certain conditions certain results would follow. The inverse relationship between price
and demand would be valid only when tastes and preferences, customs and habits of consumers,
prices of related goods, and income of consumers would remain constant.
1.5 EXCEPTIONS TO THE LAW OF DEMAND
Generally speaking, customers would buy more when price falls in accordance with the law of
demand. Exceptions to law of demand states that with a fall in price, demand also falls and
with a rise in price demand also rises. This can be represented by rising demand curve. In
other words, the demand curve slopes upwards from left to right. It is known as an exceptional
demand curve or unusual demand curve.

15
Following are the exception to the law of demand
1. Giffen’s Paradox
A paradox is a foolish or absurd statement, but it will be true. Sir Robert Giffen, an Irish
Economists, with the help of his own example (inferior goods) disproved the law of demand. The
Giffen’s paradox holds that “Demand is strengthened with a rise in price or weakened with a
fall in price”. He gave the example of poor people of Ireland who were using potatoes and meat
as daily food articles. When price of potatoes declined, customers instead of buying greater
quantities of potatoes started buying more of meat (superior goods). Thus, the demand for
potatoes declined in spite of fall in its price.
2. Veblen’s effect
Thorstein Veblen, a noted American Economist contends that there are certain commodities
which are purchased by rich people not for their direct satisfaction, but for their ’snob – appeal’
or ‘ostentation’.Veblen’s effect states that demand for status symbol goods would go up with
a arise in price and vice-versa. In case of such status symbol commodities it is not the price
which is important but the prestige conferred by that commodity on a person makes him to go for
it. More commonly cited examples of such goods are diamonds and precious stones, world
famous paintings, commodities used by world figures, personalities etc. Therefore, commodities
having ’snob – appeal’ are to be considered as exceptions to the law of demand.
3. Fear of shortage
When serious shortages are anticipated by the people, (e.g., during the war period) they purchase
more goods at present even though the current price is higher.
4. Fear of future rise in price
If people expect future hike in prices, they buy more even though they feel that current prices are
higher. Otherwise, they have to pay a still high price for the same product.
5. Speculation
Speculation implies purchase or sale of an asset with the hope that its price may rise of fall
and make speculative profit. Normally speculation is witnessed in the stock exchange market.
People buy more shares only when their prices show a rising trend. This is because they get more
profit, if they sell their shares when the prices actually rise. Thus, speculation becomes an
exception to the law of demand.
6 Conspicuous necessaries
Conspicuous necessaries are those items which are purchased by consumers even though
their prices are rising on account of their special uses in our modern style of life.
In case of articles like wrist watches, scooters, motorcycles, tape recorders, mobile phones etc
customers buy more in spite of their high prices.
7. Emergencies
During emergency periods like war, famine, floods cyclone, accidents etc., people buy certain
articles even though the prices are quite high.
8. Ignorance
Sometimes people may not be aware of the prices prevailing in the market. Hence, they buy
more at higher prices because of sheer ignorance.
9. Necessaries
Necessaries are those items which are purchased by consumers whatever may be the price.
Consumers would buy more necessaries in spite of their higher prices.
Changes or Shifts in Demand

16
It is to be clearly understood that if demand changes only because of changes in the price of the
given commodity in that case there would be only either expansion or contraction in demand.
Both of them can be explained with the help of only one demand curve. If demand changes not
because of price changes but because of other factors or forces, then in that case there
would be either increase or decrease in demand. If demand increases, there would be forward
shift in the demand curve to the right and if demand decreases, then there would be backward
shift in the demand cure.

Determinates of demand and demand function

Demand for a commodity or service is determined by a number of factors. All such factors are
called as ‘demand determinants’.
1. Price of the given commodity, prices of other substitutes and/or complements, future expected
trend in prices etc.
2. General Price level existing in the country (inflation or deflation)
3. Level of income and living standards of the people.
4. Size, rate of growth and composition of population.
5. Tastes, preferences, customs, habits, fashion and styles
6. Publicity, propaganda and advertisements.
7. Quality of the product.
8. Profit margin kept by the sellers.
9. Weather and climatic conditions.
10. Conditions of trade- boom or prosperity in the economy.
11. Terms & conditions of trade.
12. Governments’ policy- taxation, liberal or restrictive measures.
13. Level of savings & pattern of consumer expenditure.
14. Total supply of money circulation and liquidity preference of the people.
15. Improvements in educational standards etc.
Thus, several factors are responsible for bringing changes in the demand for a product in the
market. A business executive should have the knowledge and information about all these factors
and forces in order to finalize his own production marketing and other business strategies.
Demand function
The demand function for a product explains the quantities of a product demanded due to
different factors other than price in the market at a particular point of time

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1.6 MEANING AND DEFINITION OF ELASTICITY
The term elasticity is borrowed from physics. It shows the reaction of one variable with
respect to a change in other variables on which it is dependent. Elasticity is an index of
reaction.
In economics the term elasticity refers to a ratio of the relative changes in two quantities. It
measures the responsiveness of one variable to the changes in another variable.
Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand
to a given change in the price of a commodity. It refers to the capacity of demand either to
stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative
changes in two quantities.ie, price and demand. According to prof. Boulding. “Elasticity of
demand measures the responsiveness of demand to changes in price”.1 In the words of
Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according
to as the amount demanded much or little for a given fall in price, and diminishes much or little
for a given rise in price” 2
Kinds of elasticity of demand
Broadly speaking there are five kinds of elasticities of demand. We shall discuss each one of
them in some detail.
Price Elasticity of Demand
Price elasticity of demand is one of the important concepts of elasticity which is used to describe
the effect of change in price on quantity demanded. In the words of
Prof. .Stonier and Hague, price elasticity of demand is a technical term used by economists to
explain the degree of responsiveness of the demand for a product to a change in its price. It is
measured by using the following formula.

Original demand = 20 units original price = 6 – 00

New demand = 60 units New price = 4 – 00
In the above example, price elasticity is – 6.
Based on numerical values of the co-efficient of elasticity, we can have the following five
degrees of price elasticity of demand.
Different Degree of Price Elasticity of Demand

1. Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite
change in demand. The demand cure is a horizontal line and parallel to OX axis. The
numerical co-efficient of perfectly elastic demand is infinity (ED=00)

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1. Perfectly Inelastic Demand: In this case, what ever may be the change in price, quantity
demanded will remain perfectly constant. The demand curve is a vertical straight line and
parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes
from Rs. 10.00 to Rs. 2.00. Hence, the numerical co-efficient of perfectly inelastic
demand is zero. ED = 0

1. Relative Elastic Demand: In this case, a slight change in price leads to more than
proportionate change in demand. One can notice here that a change in demand is more
than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls
by 3 % and demand rises by 9 %. Hence, the numerical co-efficient of demand is greater
than one.

1. Relatively Inelastic Demand In this case, a large change in price, say 8 % fall price,
leads to less than proportionate change in demand, say 4 % rise in demand. One can
notice here that change in demand is less than that of change in price. This can be
represented by a steeper demand curve. Hence, elasticity is less than one.

19
In all economic discussion, relatively elastic demand is generally called as ‘elastic demand’ or
‘more elastic’ demand while relatively inelastic demand is popularly known as ‘inelastic
demand’ or ‘less elastic demand’.

1. Unitary elastic demand: In this case, proportionate change in price leads to equal
proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase
in demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic
demand but it is a rare phenomenon.

Out of five different degrees, the first two are theoretical and the last one is a rare possibility.
Hence, in all our general discussion, we make reference only to two terms-relatively elastic
demand and relatively inelastic demand.
Determinants of Price Elasticity of Demand
The elasticity of demand depends on several factors of which the following are some of the
important ones.
1. Nature of the Commodity
Commodities coming under the category of necessaries and essentials tend to be inelastic
because people buy them whatever may be the price.
2. Existence of Substitutes
Substitute goods are those that are considered to be economically interchangeable by
buyers.
3. Number of uses for the commodity
Single-use goods are those items which can be used for only one purpose and multiple-use
goods can be used for a variety of purposes. If a commodity has only one use (singe use
product) then in that case, demand tends to be inelastic because people have to pay more prices if
they have to use that product for only one use.
4. Durability and reparability of a commodity
Durable goods are those which can be used for a long period of time. Demand tends to be
elastic in case of durable and repairable goods because people do not buy them frequently.

20
5. Possibility of postponing the use of a commodity
In case there is no possibility to postpone the use of a commodity to future, the demand tends to
be inelastic because people have to buy them irrespective of their prices.
6. Level of Income of the people
Generally speaking, demand will be relatively inelastic in case of rich people because any
change in market price will not alter and affect their purchase plans. On the contrary, demand
tends to be elastic in case of poor.
7. Range of Prices
There are certain goods or products like imported cars, computers, refrigerators, TV etc, which
are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In
all these case, a small fall or rise in prices will have insignificant effect on their demand. Hence,
demand for them is inelastic in nature. However, commodities having normal prices are elastic in
nature.
8. Proportion of the expenditure on a commodity
When the amount of money spent on buying a product is either too small or too big, in that case
demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand,
the amount of money spent is moderate; demand in that case tends to be elastic. For example,
vegetables and fruits, cloths, provision items etc.
9 Habits
When people are habituated for the use of a commodity, they do not care for price changes over a
certain range. For example, in case of smoking, drinking, use of tobacco etc. In that case,
demand tends to be inelastic. If people are not habituated for the use of any products, then
demand generally tends to be elastic.
10. Period of time
Price elasticity of demand varies with the length of the time period. Generally speaking, in the
short period, demand is inelastic because consumption habits of the people, customs and
traditions etc. do not change. On the contrary, demand tends to be elastic in the long period
where there is possibility of all kinds of changes.
11. Level of Knowledge
Demand in case of enlightened customer would be elastic and in case of ignorant customers, it
would be inelastic.
12. Existence of complementary goods
Goods or services whose demands are interrelated so that an increase in the price of one of
the products results in a fall in the demand for the other products. Goods which are jointly
demanded are inelastic in nature. For example, pen and ink, vehicles and petrol, shoes and cocks
etc have inelastic demand for this reason. If a product does not have complements, in that case
demand tends to be elastic. For example, children snack, biscuits, chocolates, ice-creams etc. In
this case the use of a product is not linked to any other products.

13. Purchase frequency of a product

If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea,
milk, match box etc. on the other hand, if people buy a product occasionally, in that case demand
tends to be elastic for example, durable goods like radio, tape recorders, refrigerators etc.
Thus, the demand for a product is elastic or inelastic will depend on a number of factors.
Measurement of price elasticity of demand

21
There are different methods to measure the price elasticity of demand and among them the
following two methods are most important ones.
1. Total expenditure method.
2. Point method.
3. Arc method.
1. Total Expenditure Method
Under this method, the price elasticity is measured by comparing the total expenditure of
the consumers (or total revenue i.e., total sales values from the point of view of the seller)
before and after variations in price. We measure price elasticity by examining the change in
total expenditure as a result of change in the price and quantity demanded for a commodity.
Total expenditure = Price per unit x Total quantity purchased
Price in (Rs.) Qty Demanded Total expenditure Nature of PED
I Case 5.00 2000 10000
4.00 3000 12000 >1
2.00 7000 14000
II Case 5.00 2000 10000
4.00 2500 10000 =1
2.00 5000 10000
III Case 5.00 2000 10000
4.00 2200 8000 <1
2.00 4200 8400
Note:
1. When new outlay is greater than the original outlay, then ED > 1.
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.
Graphical Representation

From the diagram it is clear that

1. From A to B price elasticity is greater than one.
2. From B to C price elasticity is equal than one.
3. From C to D price elasticity is lesser than one.
2. Point Method:
Prof. Marshall advocated this method. The point method measures price elasticity of the
demand. At different points on a demand curve. Hence, in this case attempt is made to
measure small changes in both price and demand.
Graphical representation

22
The simplest way of explaining the point method is to consider a linear or straight- line demand
curve. Let the straight – line demand curve be extended to meet the two axis X and Y when a
point is plotted on the demand curve, it divides the curve into two segments. The point elasticity
is measured by the ration of lower segment of the demand curve below, the given point to the
upper segment of the curve above the point. Hence.

In short, e = L / U where e stands for Point elasticity, L for lower segment and U for upper
segment.
In the diagram AB is the straight line demand curve and P is is a given point. PB is the lower
segment and PA is the upper segment.

In the diagram, AB is the straight-line demand curve and P is a give point PB is the lower
segment and PA is the upper segment.
E = L / U = PB / PA
If after the actual measurement of the two parts of the demand curve, we find that
PB = 3 CMs and PA = 2 CMs then elasticity at Point P is 3 / 2 = 1.5
If the demand curve is non–linear then we have to draw a tangent at the given point extending it
to intersect both axes. Point elasticity is measure by the ratio of the lower part of the tangent
below that given point to the upper part of the tangent above the point. Then, elasticity at point P
can be measured as PB / PA.
In case of point method, the demand function is continuous and hence, only marginal changes
can be measured. In short, Ep is measured only when changes in price and quantity demanded
are small.
3. Arc Method
This method is suggested to measure large changes in both price and demand. When elasticity is
measured over an interval of a demand curve, the elasticity is called as an interval or Arc
elasticity. It is the average elasticity over a segment or range of the demand curve. Hence, it
is also called as average elasticity of demand.
The following formula is used to measure Arc elasticity.

Illustration
23
 P1 = original price 10 – 00. Q1 = original quantity = 200 units

P2 = New price 05 – 00 Q2 = New quantity = 300units By substituting the values in

to the equation, we can find out Arc elasticity of demand.

In the diagram, in order to measure arc elasticity between two points M & N on the demand
curve, one has to take the average of prices OP1 and OP2 and also the average quantities of Q1
& Q2.
INCOME ELASTICITY OF DEMAND
Income elasticity of demand may be defined as the ratio or proportionate change in the
quantity demanded of a commodity to a given proportionate change in the income. In short,
it indicates the extent to which demand changes with a variation in consumers income. The
following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00

New demand = 700 units New Income = 6000-00
Generally speaking, Ey is positive. This is because there is a direct relationship between income
and demand, i.e. higher the income; higher would be the demand and vice-versa. On the basis of
the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to
one, equal to zero, and negative. The concept of Ey helps us in classifying commodities into
different categories.
1. When Ey is positive, the commodity is normal [used in day-to-day life]
2. When Ey is negative, the commodity is inferior. .For example Jowar, beedi etc.
3. When Ey is positive and greater than one, the commodity is luxury.
4. When Ey is positive, but less than one, the commodity is essential.
5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.
Cross Elasticity of Demand

24
It may be defined as the proportionate change in the quantity demanded of a particular
commodity in response to a change in the price of another related commodity. In the words
of Prof. Watson cross elasticity of demand is the percentage change in quantity associated with a
percentage change in the price of related goods. Generally speaking, it arises in case of
substitutes and complements. The formula for calculating cross elasticity of demand is as
follows.
Ec = Percentage change in quantity demanded commodity X
Percentage change in the price of Y

Price of Tea rises from Rs. 4-00 to 6 -00 per cup

Demand for coffee rises from 50 cups to 80 cups.
Cross elasticity of coffee in this case is 1.6.
It is to be noted that-
1. Cross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.
2. High cross elasticity of demand exists for those commodities which are close substitutes. In
other words, if commodities are perfect substitutes For example Bata or Corona Shoes, close up
or pepsodent tooth paste, Beans and ladies finger, Pepsi and coca cola etc.
3. The cross elasticity is zero when commodities are independent of each other. For example,
stainless steel, aluminum vessels etc.
4. Cross elasticity between two goods is negative when they are complementaries. In these cases,
rise in the price of one will lead to fall in the quantity demanded of another commodity For
example, car and petrol, pen and ink.etc.
Advertising or Promotional Elasticity of Demand.
Most of the firms, in the present marketing conditions spend considerable amounts of money on
advertisement and other such sales promotional activities with the object of promoting its sales.
Advertising elasticity refers to the responsiveness demand or sales to change in advertising
or other promotional expenses. The formula to calculate the advertising elasticity is as follows.

Original sales = 10,000 units original advertisement expenditure = 800-00

New sales = 50,000 units new advertisement expenditure = 2000-00
In the above example, advertising elasticity of demand is 1.67. it implies that for every one
time increase in advertising expenditure, the sales would go up 1.67 times Thus, Ea is more than
one.

Substitution Elasticity of Demand.

25
It measures the effects of the substitution of one commodity for another. It may be defined as
the proportionate change in the demand ratios of two substitute goods X and y to the
proportionate change in the price ratio of two goods X and Y The following formulas is used
to measure substitution elasticity of demand.

Where Dx / Dy is ratio of quantity demanded of two goods X & Y.

Delta DX / Dy is the change in the quantity ratio of two goods X & Y.
PX / Py is the price ratio of two goods X & Y.
Delta PX / PY is change in price ratio of two goods X & Y
1.7 USES OF ELASTACITY

Practical application of price elasticity of demand

1. Production planning: It helps a producer to decide about the volume of production. If the
demand for his products is inelastic, specific quantities can be produced while he has to produce
different quantities, if the demand is elastic.
2. Helps in fixing the prices of different goods: It helps a producer to fix the price of his
product. If the demand for his product is inelastic, he can fix a higher price and if the demand is
elastic, he has to charge a lower price. Thus, price-increase policy is to be followed if the
demand is inelastic in the market and price-decrease policy is to be followed if the demand is
elastic. Similarly, it helps a monopolist to practice price discrimination on the basis of elasticity
of demand.
2. Helps in fixing the rewards for factor inputs: Factor rewards refer to the price paid for
their services in the production process. It helps the producer to determine the rewards for
factors of production. If the demand for any factor unit is inelastic, the producer has to pay
higher reward for it and vice-versa.
3. Helps in determining the foreign exchange rates: Exchange rate refers to the rate at
which currency of one country is converted in to the currency of another country. It helps in
the determination of the rate of exchange between the currencies of two different nations. For
e.g. if the demand for US dollar to an Indian rupee is inelastic, in that case, an Indian has to pay
more Indian currency to get one unit of US dollar and vice-versa.
4. Helps in determining the terms of trade: - It is the basis for deciding the ‘terms of trade’
between two nations. The terms of trade implies the rate at which the domestic goods are
exchanged to foreign goods. For e.g. if the demand for Japan’s products in India is inelastic, in
that case, we have to pay more in terms of our commodities to get one unit of a commodity from
Japan and vice-versa.
5. Helps in fixing the rate of taxes:-Taxes refer to the compulsory payment made by a
citizen to the government periodically without expecting any direct return benefit from it. It
helps the finance minister to formulate sound taxation policy of the country. He can impose more

26
taxes on those goods for which the demand is inelastic and fewer taxes if the demand is elastic in
the market.
6. Helps in Declaration of Public Utilities :- Public utilities are those institutions which
provide certain essential goods to the general public at economical prices. The Government
may declare a particular industry as ‘public utility’ or nationalize it, if the demand for its
products is inelastic.

7. Poverty in the Midst of Plenty:

The concept explains the paradox of poverty in the midst of plenty. A bumper crop of rice or
wheat instead of bringing prosperity to farmers may actually bring poverty to them because the
demand for rice and wheat is inelastic. Thus, the concept of price elasticity of demand has great
practical application in economic theory.

Practical application of income elasticity of demand

1. Helps in determining the rate of growth of the firm: - If the growth rate of the economy
and income growth of the people is reasonably forecasted, in that case it is possible to predict
expected increase in the sales of a firm and vice-versa.
2. Helps in the demand forecasting of a firm: - It can be used in estimating future demand
provided the rate of increase in income and Ey for the products are known. Thus, it helps in
demand forecasting activities of a firm.
3. Helps in production planning and marketing: - The knowledge of Ey is essential for
production planning, formulating marketing strategy, deciding advertising expenditure and
nature of distribution channel etc in the long run.
4. Helps in ensuring stability in production:-Proper estimation of different degrees of income
elasticity of demand for different types of products helps in avoiding over-production or under
production of a firm. One should also know whether rise or fall in come is permanent or
temporary.
5. Helps in estimating construction of houses :-The rate of growth in incomes of the people
also helps in housing programs in a country. Thus, it helps a lot in managerial decisions of a firm.

Practical application of cross elasticity of demand

1. Helps at the firm level: - Knowledge of cross elasticity of demand is essential to study the
impact of change in the price of a commodity which possesses either substitutes or
complementaries. If accurate measures of cross elasticities are available, a firm can forecast the
demand for its product and can adopt necessary safe guard against fluctuating prices of
substitutes and complements. The pricing and marketing strategy of a firm would depend on the
extent of cross elasticities between different alternative goods.
2. Helps at the industry level: - Knowledge of cross elasticity would help the industry to know
whether an industry has any substitutes or complementaries in the market. This helps in
formulating various alternative business strategies to promote different items in the market.

Practical application of advertising elasticity of demand

The study of advertising elasticity of demand is of paramount importance to a firm in recent
years because of fierce competition.

27
1. Helps in determining the level of prices: - The level of prices fixed by one firm for its
product would depend on the amount of advertisement expenditure incurred by it in the market.

2. Helps in formulating appropriate sales promotional strategy: - The volume of

advertisement expenditure also throws light on the sales promotional strategies adopted by a firm
to push off its total sales in the market. Thus, it helps a firm to stimulate its total sales in the
market.
3. Helps in manipulating the sales: - It is useful in determining the optimum level of sales in
the market. This is because the sales made by one firm would also depend on the total amount of
money spent on sales promotion of other firms in the market.

Practical Application Of Substitution Elasticity Of Demand

The concept of substitution elasticity is of great importance to a firm in the context of availability
of various kinds of substitutes for one factor inputs to another. For example, let us assume one
computer can do the job of 10 laborers and if the cost of computer becomes cheaper than
employing workers, in that case, a firm would certainly go for substituting workers for
computers. .An employer would always compare the cost of different alternative inputs and
employ those inputs which are much cheaper than others to cut down his cost of operations.
Thus, the concept of elasticity of demand has great theoretical as well as practical application in
economic theory.

1.8 DEMAND FORECASTING

Introduction
An important aspect of demand analysis from the management point of view is concerned with
forecasting demand for products, either existing or new. Demand forecasting refers to an
estimate of most likely future demand for product under given conditions. Such forecasts are of
immense use in making decisions with regard to production, sales, investment, expansion,
employment of manpower etc., both in the short run as well as in the long run. Forecasts are
made at micro level and macro level. There are different methods of forecasts like survey
methods and statistical methods generally for the existing products and for new products
depending upon the nature, number of methods like evolutionary approach substitute approach,
growth curve approach etc.
Meaning and Features
Demand forecasting seeks to investigate and measure the forces that determine sales for existing
and new products. Demand Forecasting refers to an estimation of most likely future demand
for a product under given conditions.
Important features of demand forecasting

 It is basically a guess work – but it is an educated and well thought out guesswork.

 It is in terms of specific quantities

 It is undertaken in an uncertain atmosphere.

28
  A forecast is made for a specific period of time which would be sufficient to take a
decision and put it into action.

 It is based on historical information and the past data.

 It tells us only the approximate demand for a product in the future.

 It is based on certain assumptions.

 It cannot be 100% precise as it deals with future expected demand

Demand forecasting is needed to know whether the demand is subject to cyclical fluctuations or
not, so that the production and inventory policies, etc, can be suitably formulated
Managerial uses of demand forecasting:
In the short run:
Demand forecasts for short periods are made on the assumption that the company has a given
production capacity and the period is too short to change the existing production capacity.
Generally it would be one year period.

 Production planning: It helps in determining the level of output at various periods and
avoiding under or over production.

 Helps to formulate right purchase policy: It helps in better material management, of

buying inputs and control its inventory level which cuts down cost of operation.

 Helps to frame realistic pricing policy: A rational pricing policy can be formulated to
suit short run and seasonal variations in demand.

 Sales forecasting: It helps the company to set realistic sales targets for each individual
salesman and for the company as a whole.

 Helps in estimating short run financial requirements: It helps the company to plan the
finances required for achieving the production and sales targets. The company will be
able to raise the required finance well in advance at reasonable rates of interest.

 Reduce the dependence on chances: The firm would be able to plan its production
properly and face the challenges of competition efficiently.

 Helps to evolve a suitable labour policy: A proper sales and production policies help to
determine the exact number of labourers to be employed in the short run.
In the long run:
Long run forecasting of probable demand for a product of a company is generally for a
period of 3 to 5 or 10 years.

1. Business planning:
It helps to plan expansion of the existing unit or a new production unit. Capital budgeting of a
firm is based on long run demand forecasting.

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 2. Financial planning:
It helps to plan long run financial requirements and investment programs by floating shares and
debentures in the open market.

3. Manpower planning :
It helps in preparing long term planning for imparting training to the existing staff and recruit
skilled and efficient labour force for its long run growth.

4. Business control:
Effective control over total costs and revenues of a company helps to determine the value and
volume of business. This in its turn helps to estimate the total profits of the firm. Thus it is
possible to regulate business effectively to meet the challenges of the market.

5. Determination of the growth rate of the firm :

A steady and well-conceived demand forecasting determine the speed at which the company can
grow.

6. Establishment of stability in the working of the firm :

Fluctuations in production cause ups and downs in business which retards smooth functioning of
the firm. Demand forecasting reduces production uncertainties and help in stabilizing the
activities of the firm.

7. Indicates interdependence of different industries :

Demand forecasts of particular products become the basis for demand forecasts of other related
industries, e.g., demand forecast for cotton textile industry supply information to the most likely
demand for textile machinery, colour, dye-stuff industry etc.,

8. More useful in case of developed nations:

It is of great use in industrially advanced countries where demand conditions fluctuate much
more than supply conditions.
The above analysis clearly indicates the significance of demand forecasting in the modern
business set up.
LEVELS OF DEMAND FORECASTING
Demand forecasting may be undertaken at three different levels, viz., micro level or firm level,
industry level and macro level.
Micro level or firm level
This refers to the demand forecasting by the firm for its product.
Industry level
Demand forecasting for the product of an industry as a whole is generally undertaken by the
trade associations and the results are made available to the members. A member firm by using
such data and information may determine its market share.
Macro-level
Estimating industry demand for the economy as a whole will be based on macro-economic
variables like national income, national expenditure, consumption function, index of industrial
production, aggregate demand, aggregate supply etc,
Criteria for Good Demand Forecasting

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Apart from being technically efficient and economically ideal a good method of demand
forecasting should satisfy a few broad economic criteria. They are as follows:
Accuracy: Accuracy is the most important criterion of a demand forecast, even though cent
percent accuracy about the future demand cannot be assured. It is generally measured in terms of
the past forecasts on the present sales and by the number of times it is correct.

Plausibility: The techniques used and the assumptions made should be intelligible to the
management. It is essential for a correct interpretation of the results.

Simplicity: It should be simple, reasonable and consistent with the existing knowledge. A simple
method is always more comprehensive than the complicated one

Durability: Durability of demand forecast depends on the relationships of the variables

considered and the stability underlying such relationships, as for instance, the relation between
price and demand, between advertisement and sales, between the level of income and the volume
of sales, and so on.

Flexibility: There should be scope for adjustments to meet the changing conditions. This imparts
durability to the technique.

Availability of data: Immediate availability of required data is of vital importance to business. It

should be made available on an up-to-date basis. There should be scope for making changes in
the demand relationships as they occur.

Economy: It should involve lesser costs as far as possible. Its costs must be compared against
the benefits of forecasts

Quickness: It should be capable of yielding quick and useful results. This helps the management
to take quick and effective decisions.
Analyze different methods demand forecasting for both old and new products
Methods or Techniques of Forecasting
Broadly speaking, there are two methods of demand forecasting. They are: 1.Survey methods
and 2 Statistical methods.
Survey Methods
Survey methods help us in obtaining information about the future purchase plans of potential
buyers through collecting the opinions of experts or by interviewing the consumers. These
methods are extensively used in short run and estimating the demand for new products. There are
different approaches under survey methods. They are
A. Consumers’ interview method:
Under this method, efforts are made to collect the relevant information directly from the
consumers with regard to their future purchase plans.
Survey of buyer’s intentions or preferences: It is one of the oldest methods of demand
forecasting. It is also called as “Opinion surveys”.
Under this method, consumer-buyers are requested to indicate their preferences and willingness
about particular products. They are asked to reveal their ‘future purchase plans with respect to
specific items.

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Direct Interview Method
Under this method, customers are directly contacted and interviewed. Direct and simple
questions are asked to them.
i. Complete enumeration method
Under this method, all potential customers are interviewed in a particular city or a region.
ii. Sample survey method or the consumer panel method
Experience of the experts’ show that it is impossible to approach all customers; as such careful
sampling of representative customers is essential. Hence, another variant of complete
enumeration method has been developed, which is popularly known as sample survey method.
Under this method, different cross sections of customers that make up the bulk of the market are
carefully chosen. Only such consumers selected from the relevant market through some sampling
method are interviewed or surveyed.

C. Collective opinion method or opinion survey method

This is a variant of the survey method. This method is also known as “Sales – force polling” or
“Opinion poll method”. Under this method, sales representatives, professional experts and the
market consultants and others are asked to express their considered opinions about the volume of
sales expected in the future.
D. Delphi Method or Experts Opinion Method

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This method was originally developed at Rand Corporation in the late 1940’s by Olaf Helmer,
Dalkey and Gordon. This method was used to predict future technological changes. It has proved
more useful and popular in forecasting non– economic rather than economical variables.
It is a variant of opinion poll and survey method of demand forecasting. Under this method,
outside experts are appointed. They are supplied with all kinds of information and statistical data.
The management requests the experts to express their considered opinions and views about the
expected future sales of the company.
E. End Use or Input – Output Method
Under this method, the sale of the product under consideration is projected on the basis of
demand surveys of the industries using the given product as an intermediate product.
Statistical Method
Under this method, statistical, mathematical models, equations etc are extensively used in order
to estimate future demand of a particular product.
A. Trend Projection Method
Time series is a set of observations taken at specified time, generally at equal intervals. It depicts
the historical pattern under normal conditions. This method is not based on any particular theory
as to what causes the variables to change but merely assumes that whatever forces contributed to
change in the recent past will continue to have the same effect. On the basis of time series, it is
possible to project the future sales of a company.

The heart of this method lies in the use of time series. Changes in time series arise on account of
the following reasons:-
1. Secular or long run movements: Secular movements indicate the general conditions and
direction in which graph of a time series move in relatively a long period of time.
2. Seasonal movements: Time series also undergo changes during seasonal sales of a
company. During festival season, sales clearance season etc., we come across most
unexpected changes.
3. Cyclical Movements: It implies change in time series or fluctuations in the demand for a
product during different phases of a business cycle like depression, revival, boom etc.
4. Random movement. When changes take place at random, we call them irregular or
random movements. These movements imply sporadic changes in time series occurring
due to unforeseen events such as floods, strikes, elections, earth quakes, droughts and
other such natural calamities. Such changes take place only in the short run. Still they
have their own impact on the sales of a company.

In time series may make use of the following methods.

1. The Least Squares method.
2. The Free hand method.
3. The moving average method.
4. The method of semi – averages.
The method of Least Squares is more scientific, popular and thus more commonly used when
compared to the other methods. It uses the straight line equation Y= a + bx to fit the trend to the
data.
To calculate the trend values i.e., Yc, the regression equation used is –
Yc = a+ bx.

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 As the values of ‘a’ and ‘b’ are unknown, we can solve the following two normal equations
simultaneously.

Where,

Regression equation = Yc = a + bx
Deriving trend line

Trend projection method requires simple working knowledge of statistics, quite

inexpensive and yields fairly reliable estimates of future course of demand…
B. Economic Indicators
Economic indicators as a method of demand forecasting are developed recently. Under this
method, a few economic indicators become the basis for forecasting the sales of a company. An
economic indicator indicates change in the magnitude of an economic variable. It gives the
signal about the direction of change in an economic variable.
Demand Forecasting For A New Product
Demand forecasting for new products is quite different from that for established products. Here
the firms will not have any past experience or past data for this purpose. An intensive study of
the economic and competitive characteristics of the product should be made to make efficient
forecasts.
Professor Joel Dean, however, has suggested a few guidelines to make forecasting of demand
for new products.
a. Evolutionary approach
The demand for the new product may be considered as an outgrowth of an existing product. For
e.g., Demand for new Maruti Alto 800, which is a modified version of Old Maruti 800 can most
effectively be projected based on the sales of the old Maruti 800, the demand for new Hero
Splendor can be forecasted based on the sales of the old Splendor. Thus when a new product is

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evolved from the old product, the demand conditions of the old product can be taken as a basis
for forecasting the demand for the new product.
b. Substitute approach
If the new product developed serves as substitute for the existing product, the demand for the
new product may be worked out on the basis of a ‘market share’. The growths of demand for all
the products have to be worked out on the basis of intelligent forecasts for independent variables
that influence the demand for the substitutes. After that, a portion of the market can be sliced out
for the new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute
for a land line. In some cases price plays an important role in shaping future demand for the
product.
c. Opinion Poll approach
Under this approach the potential buyers are directly contacted, or through the use of samples of
the new product and their responses are found out. These are finally blown up to forecast the
demand for the new product.
d. Sales experience approach
Offer the new product for sale in a sample market; say supermarkets or big bazaars in big cities,
which are also big marketing centers. The product may be offered for sale through one super
market and the estimate of sales obtained may be ‘blown up’ to arrive at estimated demand for
the product.
e. Growth Curve approach
According to this, the rate of growth and the ultimate level of demand for the new product are
estimated on the basis of the pattern of growth of established products. For e.g., An Automobile
Co., while introducing a new version of a car will study the level of demand for the existing car.
f. Vicarious approach
A firm will survey consumers’ reactions to a new product indirectly through getting in touch with
some specialized and informed dealers who have good knowledge about the market, about the
different varieties of the product already available in the market, the consumers’ preferences etc.
This helps in making a more efficient estimation of future demand.
These methods are not mutually exclusive. The management can use a combination of several of
them supplement and cross check each other.

Questions from Previous Question Paper

1. What is Cross Elasticity of Demand?(3 M) (June 2016)

2. Define Managerial Economics?(3 M) (Dec. 2016)

3. Explain the Baumol’s Sales revenue maximization? (7 M) (Dec. 2014)

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4. Define Price and Income Elasticities of demand. (5 M) (Dec. 2014)

5. What is advertising and promotional elasticity of demand? Explain its determinants. (7M) (June
2017)

6. Briefly explain the scope of Managerial economics. (10 M June 2015)

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