WHAT IS ECONOMICSSince the beginning of mankind there has

always been the problem of people wanting many things and doing some sort of effort that resulted in the production of some good or service which satisfied the human want. At the basic level economics is the study of relationship between wants, efforts and satisfaction.

Economics was made compulsory for engineers in the first decade of 20th century. Institute of Mechanical Engineers (UK) found that 90% of the management decisions required some managerial responsibility and most of them were basic in nature. Hence, managerial economics was introduced in engineering and management subjects.

Economics became a systematic body of knowledge after Adam Smith who wrote “Wealth of Nations” in 1776.

Adam Smith and his followers like J.B. Say, J.S. Mill, Ricardo etc are called Classical Economists.

When Classical economics failed to solve the problem of employment during the period of great depression, Keynes wrote “The General Theory” in 1936, which was the beginning of Keynesian Economics.

The study of economics can be divided into following parts:

ConsumptionProductionExchangeDistributionPublic FinanceAnother way of dividing economics is to study

economics in two parts:Micro economics Macro economics

Definition, nature and scope of micro economics Broadly definitions of economics can be

classified as: Wealth definition (Adam Smith), Welfare definition (Marshall), Scarcity definition (Robbins)

Economics is a science as well as an art.According to one view economics is a

normative science, another view is that it is a positive science and some consider both views to be acceptable.

Study of economics covers production, consumption, exchange, distribution and public finance. Another way is to divide economics into micro economics and macro economics.

Utility AnalysisMarshall and others have given a cardinal

system to explain consumer’s behaviourCardinal system assumes measurement of

utility is possible in terms of number of units, utility from one commodity is independent of other and marginal utility of money remains same.

Utility analysis is explained with the help of two laws :Law of diminishing marginal utilityLaw of equi-marginal utility

Law of diminishing marginal utilityAs more units of a commodity is consumed

MU goes on diminishing

Quantity of commodity

UTILITY

MU curve

Law of equi-marginal utilityA consumer gets maximum satisfaction when

marginal utility of money spent on each good is same. It can be expressed by following formula also:MUx ═ MUy

Px Py

Where MUx is marginal utility of X and MUy

is marginal utility of Y. Px and Py are prices of two commodities.

Indifference Curve AnalysisHicks and Allen gave concept of Indifference Curve

to explain consumer’s behaviour which is an ordinal system. Different combinations of two commodities are considered which give the same level of satisfaction.

Indifference curve is the locus of all points that represent combinations of two commodities that give same level of satisfaction.

Definition. An indifference schedule is a list of alternative combinations in the stocks of two goods which yield equal satisfaction to the consumer.

It represents all possible combinations of two goods under consideration (in this illustration, n apples and bananas), that give the consumer equal satisfaction.

The Indifference Curve

Properties of Indifference curve1. I. curve has negative slope2. I. curve is convex to origin3. Higher I. curve has higher level of

satisfaction4. Two I. curves do not intersect each other5. I. curves do not touch any axes6. Two I. curves need not be parallel to each

other

Price Line or Budget Line It is the locus of all the

combinations of two commodities that can be purchased when prices and income are known.

OA is the max qt of A and OB is the max qt of B that can be bought, then AB is price line that shows all combinations that can be purchased. The combination z can not be bought and s will not use up all resources.

Consumer’s equilibriumConsumer equilibrium is

attained when, given his budget constraint, the consumer reaches the highest possible indifference curve. This is found where indifference curve and price line are tangent to each other, marginal rate of substitution is equal to price ratio of two commodities and indifference curve is convex to origin.

Income EffectThe income effect refers to the

change in demand for a commodity resulting from a change in the income of the consumer, prices of goods being constant.

Points of consumer’s equilibrium at different levels of income can be joined together to get income-consumption-curve (ICC)

Price EffectWhen income and

price of one item remains same and price of the other good changes then the change in equilibrium or change in consumption is price effect.

Price effect is positive for normal goods, which means demand falls with rise in price and for Giffen goods it is negaive, which means changes in price and demand are in the same direction. Locus of equilibrium at different prices is price-consumption-curve (PCC)

Substitution EffectWhen price of one good is increased and price

of the other is decreased, income remains same then consumer substitutes cheaper good in place of more expensive one to remain at the same level of satisfaction. This change in consumption or equilibrium is known as substitution effect. This is always positive, which means that cheaper commodity is always substituted for expensive commodity.

Demand FunctionMathematical of expression of functional relationship between determinants (such as price, income, etc., determining variables) and the amount of demand of a given product.In composing the demand function for a product, therefore, one should identify and enlist the most important factors (key variables) which affect its demand. To suggest a few, such as:

• The ‘own price’ of the product itself (P)• The price of the substitute and complementary goods (Ps or Pc)• The level of disposable income (Yd) with the buyers (i.e., income left after

direct taxes)• Change in the buyers’ taste and preferences (T)• The advertisement effect measured through the level of advertising

expenditure (A)• Changes in population number or the number of the buyers (N).

Using the symbolic notations, we may express the demand function, as follows:Dx = f (Px, Ps, Pc, Yd, T, A, N, u)

Demand Schedule

A tabular statement of price/quantity relationship is called the demand schedule.

Individual Demand Schedule

A Market Demand Schedule (Hypothetical Data)

Market Demand CurveIn graphical terms, a market demand curve for a product is derived through the horizontal summation of all individual buyer’s demand curves for the given product.

Demand CurveDemand curve refers to the graph of a demand schedule, measuring price on the Y-axis and quantity demand on the X-axis. Usually, a demand curve has a downward slope, representing an inverse relationship between price and demand.

A Linear Demand Curve

The Law of Demand

The conventional law of demand, however, relates to the much simplified demand function:

D = f (P)

Demand Curve

Assumptions Underlying the Law of DemandNo change in consumer’s income

No change in consumer’s preferences

No change in the fashion

No change in the price of related goods

No expectation of future price changes or shortages

No change in size, age composition and sex ratio of the population

No change in the range of goods available to the consumers

No change in the distribution of income and wealth of the community

No change in government policy

No change in weather conditions

Exceptions Demand Curve: Upward-sloping Demand Curve

Exceptional CasesGiffen goodsArticles of snob appealSpeculationConsumer’s psychological bias or Iillusion

ELASTICITY OF DEMANDIt refers to the responsiveness of demand to

any change like change in price, income or price of another commodity. Elasticity of demand is measured as the ratio of percentage change in the quantity demanded of a product to the percentage change in its price.

Types of Elasticity of DemandPrice elasticity of demand: Extent or rate of

change in demand due to change in price.Income Elasticity of demand: Extent or rate

of change in demand due to change in income.

Cross Elasticity of demand: Extent or rate of change in demand due to change in price of related good.

Degree of Elasticity of demandEach type of elasticity can have five degrees:1. Unitary inelastic demand (e=1)

2. Perfectly inelastic demand (e=0

3. Highly elastic demand (e>1)

4. Less Elastic demand (e<1)

5. Perfectly Elastic demand (e= infinity)

Measurement of Elasticity of demand

1.Proportionate method: When information is available about original price, original quantity and changes in them and the changes are small then this method is applied:

El= (P/Q) (Change in Q/ change in P)2. Total Outlay method: When change in

expenditure on a product before change in P and after change in P is known, then this method is applied. There are two cases:

When the price of commodity falls

If total expenditure remains same, e=1If total outlay falls then, e<1If total outlay rises then, e>1

When the price of commodity rises

If total expenditure remains same, e=1If total outlay falls then, e>1

If total outlay rises then, e<1

3. Point method: This method is used when elasticity has to be measured on a point on the demand curve. In case of linear demand curve, elasticity of demand is measured by dividing the lower segment from the point on demand curve, by the upper segment of the demand curve.In case of non-linear demand curve, a tangent is drawn at the point on the demand curve at which elasticity is to be measured and follow the same formula as in the last case.

4. Arc Method: This is used when information is available regarding old and new prices and demand at respective prices and the changes are large. The formula is similar to the one used in Proportionate method, only difference is that in place of original price, new price is added to original price and in place of original quantity, new quantity is added to original.

5. Revenue Method: If we have information about AR and MR then elasticity of demand can be calculated by formula

E= (AR-MR) / AR

Factors affecting Elasticity of demandNature of commodityAvailability of substitutesNumber of usesConsumer’s incomeHeight of price and range of price changeProportion of expenditureDurability of the commodityComplementary goodsTimeRecurrence of demandPossibility of postponement

Demand Forecasting Demand forecasting means predicting future marked

demand and its magnitude on the basis of statistical data and empirical measurement of functional relationship bet-ween demand and its determinants.

It is required for the following reasons:Production planning. Acquiring inputs and provision of finance Inventory control. Growth and long-term investment programs

Methods of demand forecasting1. Survey of potential consumers2. Expert’s opinion3. Statistical methods4. Econometric methodsLimitations: Reliability of results depends on

many factors: Choice of variables and data; form of the demand function used; quality of data available etc.

Production Function

It refers to the physical relationship bet-ween the use of the inputs (factors of production) and resulting output of a product.

Short-run Production Function

In the factor combinations of an input, at least one factor re-mains fixed in the process of production.

Law of Variable Proportion

The law pertaining to the return to a variable factor input.

Total Pro-ductTotal quantity of output produced by the given use of input in the production system, per un-it of time.

Average ProductTotal quantity of pro-duct divided by the total units of input employed. It is per factor unit product.

Marginal ProductThe addition made to the total product associated with a one-unit change in a particular single in-put labour

Statement. Using the concept of marginal product, the law may be stated as follows:During the short period, under the given state of technology and other conditions remaining unchanged, with the given fixed factors, when the units of a variable factor are increased in the production function in order to increase the total product, the total product initially may rise at an increasing rate and, after a point, it tends to increase at a decreasing rate because the marginal product of the variable factor in the beginning may tend to rise but eventually tends to diminish.

The Product Curves

Return to ScaleOutput resulting on account of a proportional increase in the whole set of inputs.

Output ElasticityThe percentage change in output quantity divided by the percentage change in input quantity.

Returns to Scale

Output Elasticity

Output elasticity is defined as the ratio of the percentage change in quantity produced to the percentage change in factor input.

Isoquant

The same specific output quantity most efficiently produced by the different input combinations of two factors; say, labour and capital.

Equal Product Curves

Risk-Return Indifference Curve

Least-Cost Combination

Ridge LineA graphical bound suggesting the limit be-yond which marginal products becoming negative.

Isocost LineThe budget line of the firm expressed in terms of constant costs.

Types of Production Costs and their MeasurementIn economic analysis, the following types of costs are

considered in studying cost data of a firmTotal Cost (TC)Total Fixed Cost (TFC),Total Variable Cost (TVC)Average Fixed Cost (AFC),Average Variable Cost (AVC),Average Total Cost (ATC), andMarginal Cost (MC).

Marginal Costs

The additional costs relating to each successive unit-wise increment in total output. It is measured on the ratio of change in total cost to one unit change in total output.

Symbolically, thus, MC = where, D denote change in output assumed to change by 1 unit only.

Therefore, output change is denoted by D1.

The Short Run Total Costs Schedule of a Firm (Hypothetical Data)

Short Run Total Cost Curves

Short Run Average Cost Curves

Short-run Average cost (SAC) Curve

U shaped indicating declining SAC in the beginning, then remaining constant for a while and then rising.

Relationship between AC and MC Curves

Costs FunctionIt is mathematical expression of functional relationship between the costs and out-put level. Cost Function of a Hosiery MillJoel Dean (1941), estimated the total cost behaviour of a hosiery knitting mill in the U.S. by fitting a simple regression equation of the form: TC = b1 + b2 to the data, thus:

TC = 2953.59 + 1.998Q(6109.83)

where, TC = total cost in dollarsQ = output in dozens of pairs(parenthesis represent the standard error of estimate)

Derivation of the LAC Curve

Long-Run Average Costs CurveIt relates to the cost-output relation in the long-run. It is a flatter U-shaped curve.

The LMC and the LAC Curves

Internal Economies-Diseconomies and the LAC Curve

The Effect of External Economies

The Effect of External Diseconomies

Minimum Efficient Scale

It refers to the lowest point on the long-run average cost curve, implying optimum use of factor-input and minimum average cost.

The amount of money received from the sale of products of a firm is known as revenue

Following are the main concepts of revenue:

Total Revenue: It is the total sales receipts of a firm. TR= P X Q

Average Revenue: It is the revenue earned from sale of one unit of product. It is same as price of a product.

Marginal Revenue: It is the change in total revenue from a unit change in the output sold.

Revenue curves of firms

Industry Demand and Firm Demand under Perfect Competition