UNIT-I

Meaning, Nature and Scope of Economics

The word economics has been derived from two Greek words; Oikos which means household and Neimein which means management. Thus the literary meaning of economics is the study of management of the household. Further it implies that economics is that domain of knowledge which is concerned with the management of unlimited wants with limited resources by household. The definition of economics has undergone perceptible changes. Broadly speaking, the various definitions of economics can be listed under the following heads:-

Wealth Definition

Welfare Definition

Scarcity Definition

Growth Definition

Wealth Definition:- This definition was given by Adam Smith in his book An Inquiry into the nature and causes of wealth of Nations published in 1776.As the title of book suggests that Adam Smith defines economics as the study of the nature and causes of the generation of wealth of a nation. According to Adam Smith Goods have both value-in-use (utility) and value-in-exchange (price).He defined wealth as all the goods which command value-in- exchange. He says that economics seeks to explain and analyse the generation of wealth and also its distribution. In this definition Smith has tried to explain the factors which are responsible for the generation of wealth. He argued that the larger amount of wealth and betterment of the whole society could be achieved by efficient allocation of resources through the market mechanism. In spite of all the merits, the wealth definition has been criticized.

Criticism:-

It has given all the emphasis on wealth and ignored man and his welfare.

Adam Smith has restricted the meaning of wealth as he included in wealth only material goods like tea, biscuits, and butter etc. and excluded immaterial goods like the services of the doctors, soldiers and teachers etc.

He gave the concept of economic man who satisfies his own interest without having the social interests.

He says wealth as an end in itself but does not explain the means to achieve it.

Welfare Definition: - This definition was given Alfred Marshall in his book Principles of Economics which was published in the year 1980.Marshall defines economics as the science of welfare. In his definition the emphasis was shifted from wealth to man and also from wealth to welfare. According to Marshall, Economics is a study of mans actions in the ordinary business of life. It enquires how man gets his income and how he spends it. Thus it is on the one hand the study of wealth and on the other and most important side, a part of the study of man. He pointed out that wealth is not an end in itself but it is only a means to an end and the end is the promotion of human welfare. Through welfare definition of Marshall, no doubt, is a great improvement over the wealth definition of Adam Smith, it is also not free from the criticism.

Criticism

Marshalls view of economics is narrow and unscientific.

Material welfare cant be measured by any scale and cant be accepted as an end of economics.

It included only material welfare and excluded non- material welfare.

Marshall offered normative view of economics. But economics is neutral between ends and does not give value judgment.

Scarcity Definition: - This definition was given by Leonel Robbins. He defines economics as a science of scarcity or choice in his famous book An Essay on the Nature and Significance of Economic Science published in the year 1932.According to Robbins, Economics is the science which studies the human behavior as a relationship between ends and scarce means which have alternative uses.

This definition has the following fundamental features:-

Unlimited Wants (ends)

Limited Means

Limited means have the alternative uses.

This definition is analytical rather than classificatory. It focused on a particular aspect of behaviour, eg. Behavior concerned with the utilization of scarce resources to achieve unlimited wants.

Criticism:-

The concept of ends and means is not in conformity to human actions.

Knight has criticized that economics is only concerned with means and not ends. It should discuss the alternative ends and not only means for a given end.

Robbins has reduced economics merely to the value theory. Theory of economic growth now a day has become a very important branch of economics but Robbins definition does not cover it.

Robertson has criticized this definition and says that this definition is too narrow and too wide. It is too narrow because it excludes the concepts like- employment policy, relation between capital and labour etc. It is too wide because the problem of resources allocation may also arise in certain other fields not generally included within the scope of economics.

In spite of these drawbacks, scarcity definition is more scientific and analytical than the older definitions and has greater degree of acceptability.

Growth Definition: - This definition was given by Paul A.Samuelson. Though Robbins definition is the most accepted one. Due to lack of practicability modern economist felt that the better allocation and efficient use of means for economic growth should also be the subject matter of economics. Thus the modern and modified definition of economics can be explained in the language of Samuelson Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce commodities over time, and distribute them for consumption now and in future among various people and groups of society. This definition is dynamic and incorporates both the problem of choice and problem of development. The subject matter of economics has become so wide, so it is difficult to define the economics in a nut shell. This definition is comprehensive and a suitable definition involving wealth, welfare, choice of economic growth. We can conclude the following points from the definition:-

Economics is a science that studies those activities which are concerned with the efficient consumption, production, exchange and distribution of scarce means which have alternative uses.

The purpose of economics is to achieve maximum satisfaction of wants and increasing of welfare as well as economic growth.

Nature of Economics

There is a difference of opinion among economists regarding the nature of economics. Some consider it as a science and some as an art. If economics is a science, then is it a positive or normative science?

Economics as a Science: - A science can be defined as systematized body of knowledge as certainable by observation and experimentations. It is a body of generalizations, principles, theories or laws which traces out a causal relationship between cause and effect. On the basis of this we can summarize for any discipline to be a science it must have the following characteristics:-

It must be systematized body of knowledge.

It should have its own methodological apparatus.

It should have its own laws and theories.

The laws and theories can be tested by observation and experimentation.

Self corrective.

Universal validity.

Arguments in Favour of Economics as a Science

Systematized body of knowledge: In economics there is a systematized collection, classification and analysis of economic facts. For example, economics is divided into consumption, production, exchanges, distribution and public finance which have their laws and theories on whose basis these departments are studied and analyzed in a systematic manner.

Scientific Laws: - Laws of economics are similar to the laws of other science. There is a causal relationship between two or more phenomenon. As in physics the law of Newton states that there is an equal and opposite reaction to every action similarly in economics, the law of demand tells that other things remaining the same, fall in price leads to increase in demand and rise in price leads to decrease in demand.

Experiments: - As experiments are the part and parcel of science so in economics. Different economic laws have been experimented. In the case of economic experiment, there is no need of laboratory and we treat the whole social and national system as laboratory. For example to control inflation government applied various monetary and fiscal measures it is an economic experiment.

Universal: - The laws of economics have the universal validity like the laws of science. The law of diminishing returns, law of demand, law of diminishing marginal utility etc. are equally applicable in all countries.

Self corrective Nature: - Like science, economics is self corrective in nature. Under new facts and observations economists revise their theories in different fields of economics related to macroeconomics, monetary economics, international economics, public finance and economic development.

Economics as an Art: - Many economists considered economics as an art. Art is the practice of knowledge. Mere knowledge or developing theories become irrelevant without practical aspects. We can conclude that an art has the following features:-

Practice of knowledge.

Art teaches to do.

Art gives solution to the problem.

Art is practical.

Arguments in Favour of Economics as a Science

Solution to the problem: - the various branches of economics provide practical solution to various economic problems. Economics solves the fundamental problems of an economy like allocation of scarce resources in satisfying the different wants.

Practical application: - The art is the practical application of knowledge. When we apply the economic law only then we come to know that whether their results are true or false. Price determination guides the policy makers to manage supply and to maintain price stability. Role of advertisement in monopolistic market, all these theories are practically applicable in day to day life to make different decisions.

Economics: A positive science or a Normative Science

Positive Economics: - Positive statements are objective statements dealing with matters of fact or the question about how things actually are. Positive statements are made without obvious value judgment and emotions. Positive economics can be described as what is, what was, and what probably will be. Positive statements are based on economic theory rather than emotion. Often these statements will be expressed in the form of a hypothesis that can be analyzed and evaluated.

Examples:

A rise in interest rates will cause a rise in the exchange rate and an increase in the demand for imported products.

Lower taxes may lead to an increase in the active labour supply.

A national minimum wage is likely to cause a concentration in the demand for low- skilled labour.

Normative Economics: - Normative statements are subjective- based on opinion only with or without a basis in fact or theory. They are more valuable statements that focus on what ought to be.

It is important to be able to distinguish between these statements particularly when heated arguments and debates are taking place.

The decision to grant autonomy to private banks is unwise and should be reversed.

A national minimum wage is totally undesirable as it does not help poor and causes higher unemployment and inflation.

The national minimum wage should be increased by 10% as a method of reducing poverty.

Protectionism is the only proper way to improve the living standards of workers whose employment is threatened by cheap imports.

Scope of economics

Stonier and Hague have divided the subject matter of economics into three categories which can be discussed as follows:-

Economic Theory: - it is theoretical part of economics. It contains economic theories and economic tools. It is divided into static and dynamic economics. It is also known as Economic Analysis.

Applied Economics: - It attempts to apply the results of economic analysis to descriptive economics. Industrial economics, managerial economics, and agricultural economics are some of the examples of applied economics.

Descriptive Economics: - In descriptive economics, relevant facts about a particular economic subject or topic are collected for the purpose of study. The subject Indian Economics is the example of descriptive economics.

We know economics as a branch of knowledge which deals with the allocation of scarce resources. The problem of resource allocation has been regularly faced by the individuals, enterprises, and nations over the years. In the field of economics in recent decades the use of mathematical tools and statistical methodology has become increasingly important. Further economics is not the study of choice making behavior only. Major national and international issues become the part of modern economic science. Currently the theory of economic growth has occupied an important place in the study of economics and it studies how the national income grows over the years.

Economics has two major branches:

Microeconomics (2) Macroeconomics

Microeconomics: It can be defined as that branch of economic analysis which studies the economic behavior of the individual unit, may be a person, a household, a firm, or a n industry. It is a study of one particular unit rather than all the units combined together. An important tool used in microeconomics is that of Marginal Analysis. Some of the important laws and principles of microeconomics have been derived directly from the marginal analysis.

The followings are the fields covered by microeconomics:

Theory of Consumer Behavior and Demand

Theory of Production and Costs

Theory of Distribution or Factor pricing

Theory of Economic Welfare

FIGURE- SCOPE OF MICRO ECONOMICS

Macroeconomics: Macroeconomics can be defined as that branch of economic analysis which studies the behaviour of not one particular unit, but of all the units combined together. Macroeconomics is a study of aggregates. It is the study of the economic system as a whole; national income, aggregate demand, aggregate supply, total consumption, total savings and total investment. The followings are the fields covered by macroeconomics:

Theory of Income, Output and Employment

Theory of Business Cycles

Theory of General Price level with theory of inflation and deflation

Theory of Economic Growth

Macro Theory of Distribution dealing with the relative shares of wages and profits in the total national income

Theory of National Income

Theory of Money

Difference between Microeconomics and Macroeconomics

Microeconomics

Macroeconomics

1

It is the study of economic actions of individuals and small groups of individuals. It includes individual household, firm, industry, particular commodity and individual price. It deals with determination of price and output in individual markets.

It is the study of aggregate. It includes national income, national output ,aggregate demand, aggregate supply, general price level etc.

2

Its central problem is price determination of commodities and factors of production.

Its central problem is the determination of level of income and employment.

3

Its main tools are demand and supply of the commodity and factor.

Its main tools are aggregate demand and aggregate supply of the economy as a whole.

4

Microeconomics is based on the partial equilibrium analysis which helps to explain the equilibrium conditions of an individual, a firm, an industry and a factor.

Macroeconomics is based on general equilibrium analysis which is an extensive study of a number of economic variables, their interrelations and interdependence for understanding the working of the economic system as a whole.

5

Its aims at optimum allocation of resources i.e. the objective of microeconomics on demand side is to maximize utility whereas on the supply side is to maximize the profits at the minimum cost.

Its aims at determination of aggregate output, national income, price level and employment level in the economy. The objectives include price stability, economic growth and balance of payment stability.

6

In microeconomics, the study of equilibrium conditions is analyzed at a particular period of time.

Macroeconomics is based on time lags, rates of change, and past and expected value of the variables in future.

Meaning of Science:

The word science comes from the Latin scientia, meaning knowledge. Science refers to a system of acquiring knowledge. The term science also refers to the organized body of knowledge gained by using a system. In other words science may be described as any systematic field of study or the knowledge gained from it. It is a systematic enterprise of gathering knowledge about the nature and organizing and condensing that knowledge into testable laws and theories.

Scientific method is the standard for science. It includes the use of careful observation, experimentation, measurement, mathematics, and replication. The use of the scientific method to make new discoveries is called scientific research. Science as defined above is sometime called pure science to differentiate it from applied science, which is the application of research to human needs. Fields of science are commonly classified in the following two ways:

Natural sciences, the study of the natural world, and

Social sciences, the systematic study of human behaviour and the society.

Meaning of Engineering: Engineering can be defined as the application of scientific and mathematical principles used for practical purpose like design, manufacture, and operation of efficient and economical structures, machines, processes, and systems.

Engineers apply the sciences of the physics and mathematics to find suitable solutions to problems. More than ever, engineers are now required to have knowledge of relevant sciences for their design projects; as a result, they keep on learning new material throughout their career. The crucial and unique task of the engineer is to identify, understand, and interpret the constraints on a design in order to produce a successful result. It is usually not enough to build a technically successful product; it must also meet further requirements. Constraints may include available resources, physical, imaginative or technical limitations, and other factors as requirements for cost, safety, marketability, productibility, and serviceability. By understanding the constraints, engineers can fix the limit within which the production can be made.

Meaning of Technology: Technology word comes from the Greek word techno logia where techno means an art, skill, or craft and logia means the study of something, or the branch of knowledge of a discipline.

Technology can be broadly defined as the entities, both material and immaterial, created by the application of mental and physical effort in order to achieve some value. In this usage, technology refers to the tools and machines that may be used to solve real-world problems.

Types of Technology

In our daily life we can observe the following types of technology:

Labour intensive technology: The technology where more laour is used in comparison to capital to produce a unit of output. It is more appropriate for the underdeveloped countries where labour is in abundance and capital is in scarce.

Capital intensive technology: The technology where more capital is used in comparison to labour to produce a unit of output. It is more appropriate for the advanced countries, where capital is in abundance and labour is in scarce.

Neutral technology: It is neither labour saving nor capital saving.

Intermediate technology: It is that technology which is midway between capital intensive technology and labour intensive technology. For example, manufacturing a washing machine which works on electricity (when electricity is available) as also can be operated by hand (when electricity is not available).

The level of technology is an important determinant of economic development of a country. Development of economy though an ongoing process and dependent upon injections of new technology is subject to constraints of its capacity to generate and absorb the technological change. Technology leads to greater output, shorter working hours and creation of skilled jobs, production of newer and better goods of standardised quality and more efficient use of raw materials.

Role of Science, Engineering and Technology

Science, Engineering and Technology have significantly affected the human ability to control and adapt to their natural environments. They have affected the society in a number of ways. Some of them may be discussed as follows:

Economic Growth: With the advent of new technology emerging from science and better machines etc. developed by engineers both industrial and agricultural growth in an economy gains momentum even with the limited resources.

Increase in Production: The adoption of new and modern technology leads to greater increase in the output of the economies of the world.

Increase in Efficiency: Better equipments and techniques lead to growth in output without a proportional increase in input which means a rise in productivity and efficiency.

Better Infrastructure: all the economies of the world are investing in infrastructure for achieving the objective of economic development. Building up of good infrastructure is largely dependent on science and technology. Safety and other specifications of an infrastructure project are taken care of by the engineers.

Better Standard of living: People of the country and of the world in general now enjoy a better standard of living with new innovations which is making life more comfortable and enjoyable. Science, engineering and technology have added both comforts as well as luxuries to the life.

Faster Means of Communication: Telephones, mobiles and internet are the gifts of science and engineering to human beings which have made the world a global village and reduced communication barriers to facilitate business and personal life.

Global Competitiveness: The countries which are technologically sound and ahead in innovations are today the leading economies of the world. In the global era only those economies can be competitive which have adopted good science and technology policies and adopting the advanced technologies.

Engineering Economics

Meaning: Engineering economics is a part of economics for application to engineering projects. Engineers seek solutions to the problems and economic viability of each potential solution is normally considered along with the technical aspects.

Characteristics of Engineering Economics

Engineering economics is a traditional and important part of engineering practice.

Engineering economics is concerned with application of economic principles in technical and managerial decision making. The broad economic principles are:-

Effects of various costs.

Production lot size on cost.

Capital investment.

Rate of depreciation

Demand and supply including forecasting

Economies of scale

Engineering economics is both microeconomics and macroeconomics in nature when applied to engineering problems. For example, the study of demand analysis is mostly concerned with individual or household as a small unit of study. Whereas, the study of impact of taxes on raw-materials is a macro concept.

Engineering economics also includes certain concepts and principles from other fields such as statistics, accounting and management etc.

Engineering economics aids decision making aspects of an engineer and it avoids the abstract nature of economic theory.

Engineering economics is mostly an application tool, whereas economics is a social science with a broad characteristic.

Engineering economics provides an analytical and scientific approach resulting in qualitative decisions.

Scope of Managerial Economics in Engineering Perspective

The scope of managerial economics can be discussed under the following heads:

It has wide scope in manufacturing, construction, mining and other engineering industries. Examples of economic application are as follows:

Selection of location and site for a new plant.

Production planning and control.

Selection of equipment and their replacement analysis.

Selection of a material handling system.

Better decision making on the part of engineers.

Efficient use of resources results in better output and economic development.

Cost of production can be reduced.

Alternative courses of action using economic principles may result in reduction of prices of goods and services.

Elimination of waste can result in application of engineering economics.

More capital will be made available for investment and growth.

Improves the standard of living with the result of better products, more wages, and salaries, more output etc. from the firm applying engineering economics.

Meaning of Managerial Economics

Managerial economics is a science which deals with the use of basic economic concepts, theories and analytical tools suitable in the decision- making process of a business firm.

In other words, managerial economics is a science which is concerned with those aspects of economic theory and its applications that are directly relevant to the managerial practice in the decision- making process of a business firm.

According to Milton H. Spencer and Louis Siegelman, Managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision- making and forward planning by management.

According to Haynes, Mote and Paul, Managerial economics is applied in decision making. It is a special branch of economics bridging the gap between abstract economic theory and managerial practice.

Bryan Carsberg defines, Managerial economics is the application of basic economic theory to the practical problems of a business firm.

Nature of Managerial Economics

Pragmatic in nature: It is pragmatic in nature because it deals with making economic theory more application- oriented. Further managerial economics is concerned with the use of analytical tools of economic theory in solving practical managerial problems and improving decision- making in business.

Micro economic in nature: Managerial economics is micro-economic in nature because it involves the application of the micro-economic concepts and theories. Microeconomics deals with the single units- single firm, single industry, single demand, price, and consumer and not with a whole. As it deals with the behaviour of small units including firm, industry so it is micro- economic in nature.

Normative in nature: Managerial economics is normative in nature because it not only deals with the different theories, principles, different dependent and independent variables but also prescribes what the firms should do in different situations keeping them in consideration. For e.g., economic theory can tell us the relationship between the price of a product and its quantity supplied but it doesnt tell us whether the outcome of this relationship is good or bad. This is positive nature of economic theory but managerial economics on the other hand not only explains the impact of change in price on supply or vice versa but also suggests whether such course of action should be taken or not. Thus managerial economics is normative in nature which generally not only tells what is but also tells us what ought to be, i.e. to suggest the best course of action.

Macro-economic in nature: Managerial Economics is macro-economic in nature because apart from studying the internal environment of a firm it also studies the external environment of the firms. The firms have to analyse the economic environment such general price level, industrial relation, taxation policy of the governments, business cycles etc. in which they take decisions. Managerial economics helps the firms to cope up with the negative impact of the external environment.

Goal-oriented: Managerial Economics is goal-oriented in nature as it mainly aims at achieving maximum objectives of the business firms. The objectives of a firm include the objective of profit maximization, sales maximization, growth maximization, long run survival etc.

Application-oriented: managerial economics is an application-oriented science in the sense that it is concerned with economics applied in practical decision-making in business.

Tool in the different fields: managerial economics serves as a tool in the study of business administration especially in the functional areas such as finance, accounting, marketing, personnel management and production management.

Scope of Managerial Economics

The scope of managerial economics includes all those economic concepts, theories and analytical tools which can be used to analyse business environment and to find solutions for practical business problems. The scope of managerial economics covers two areas of decision making which are as follows:

1. Internal or Operational Issues

Operational decisions are those which the manager takes as his official role. These are concerned with the issues which arise in within the business firms and so they are under the control of management. These decisions are delegated or distributed in different hierarchy of the management. They deal with the general aspects as what to produce, how to produce, and for whom to produce. The internal or operational issues can further be divided under the following as the scope of managerial economics:-

Demand analysis and forecasting: Demand analysis is of great importance in managerial economics. it seeks to identify and measure the factors that determine the demand for a product in the product market. The demand for a firms product reflects what the consumers actually buy. In every business firm, executive manager has to estimate current demand and forecast future demand for the output produced by the firm. Such demand decisions can be evaluated through an analysis of consumer behavior. The important aspects dealt with under demand analysis are: individual and market demand; demand estimation; demand function; demand distinctions; demand forecasting and elasticity of demand and its relevance in decision- making in business.

Demand forecasting attempts to estimate the likely demand for a product in future periods. If future demands are identified, production can be better planned.

Production analysis: Production analysis helps the firm to achieve the optimal levels in the production process. It helps to get maximum output with minimum level of inputs of a firm. The main concepts dealt under the production analysis are: production functions, returns to scale, isoquants, economies and diseconomies of scale.

Cost analysis: cost analysis plays an important role in decision-making of a business firm. It is discussed in monetary terms of the product produced in the business firm. The main aspects dealt with under cost analysis are: cost concepts, cost behaviour in the short run and long run, cost functions, cost determinants, cost control and cost reduction. Cost analysis especially deals with the various cost concepts and their practical usefulness in managerial decision-making.

Pricing analysis: pricing analysis is a core concept of managerial economics. It plays an important role in profit planning. The success of a firm depends upon correct price decisions taken by it. If the price is too high, the firm may not find enough consumers to buy its product. If the price is set too low, the firm may not be able to cover its costs. Thus, setting an appropriate price is important for every business firm. The pricing decision depends on the types of market. If the market is perfect competition, monopoly, monopolistic, oligopoly and duopoly etc, the firm takes the decision about fixation of price accordingly. The main aspects dealt with under pricing analysis are: concepts of market mechanism, price determination under different markets, pricing policies, pricing methods and approaches.

Profit analysis: profit is the index of good performance of a business firm. Generally, firms aim at making profits. But the survival of every business firm depends upon its ability to earn profit. Hence, decisions concerning level of profit, rate of profit, reinvestment of profit, etc., are relevant in every business firm now a days. The main aspects covered under the profit analysis are: nature and measurement of profit, profit theories, profit policies, profit planning and control (break-even analysis) and profit forecasting.

Investment analysis: As the capital is scarce and expensive factor of production, issues related to the decision making about it are important. The major concerning issues related to capital investment are as follows:

Choice of source of funding

The choice of investment project

Evaluation of capital efficiency

Most efficient allocation

Strategic or long term planning: Strategic or long term planning requires decisions to frame and to achieve the long term goals and objectives of a firm. Managerial economics helps a firm to come up with decisions related to the strategic planning and to achieve those strategic goals and objectives.

External or Environmental Issues

In managerial economics the external or environmental issues refer to the business environment of a firm in which it operates. These external or Environmental issues can be either political, social or economic within which the firm is operating. A study of these External or Environmental Issues include the study of:

Nature of the economic system existing in the country.

Business cycle phases through which each firm has to undergo.

Working pattern of the financial institutions like banks, insurance companies, share market etc in the country.

Trends in the foreign trade.

Trends in the labour and capital markets in the country.

Policies of the government related to industries, monetary policy, fiscal policy and pricing policy, etc.

Finally, we can conclude that external issues are dealt with the help of study of macro-economic aspects while the internal issues are dealt with the help of study of micro-economic aspects. The use of both micro-economic and macro-economic aspects for business decision making is provided by Managerial economics.

UNIT-II

Concept of Demand

In economic terminology the term demand conveys a wider and definite meaning than in the ordinary usage. Ordinarily demand means a desire, whereas in economic sense it is something more than a mere desire. It is interpreted as a want backed up by the - purchasing power. Further demand is per unit of time such as per day, per week etc. moreover it is meaningless to mention demand without reference to price.

In economics, the word demand consists of 4 main concepts:

It refers to both the ability to pay and a willingness to buy by the consumer (s).

Demand is a flow concept. Our willingness and ability to buy is subjected to a time period. At different times, we may have different demand schedules.

There are many factors affecting our demand. In order to explore the effect of price on quantity demanded, economists like to assume ceteris paribus other factors unchanged so as to make the analysis easier.

Definition of Demand

Demand for anything means the quantity of that commodity, which is bought, at a given price, per unit of time.

In Other Words:

An individual demand refers to the quantity of a good a consumer is willing to buy and able to buy at all prices within a period of time, ceteris paribus.

The demand for a commodity at a given price is more than what it would be at a higher price and less than what it would be at a lower price

In Latin, the term ceteris paribus means holding other factors constant or unchanged.

Individual Demand Schedule or Demand Table

A demand schedule is a table showing various quantities of a good that a consumer would buy at all different prices within a time period, ceteris paribus.

In mathematics, price & quantity demanded have a functional relationship. (In a demand function, price is called the independent variable and quantity demanded the dependent variable.)

A demand curve shows the above relationship in a graph.

The following example gives a demand schedule and a demand curve.

Label the X-axis & Y-axis first, and then draw the curve.

A Demand Schedule for A Good of A Consumer

Price ($ per uint)

Quantity Demanded

30

2

20

4

15

6

12

8

10

10

8

12

It can be observed that with a fall in price every individual consumer buys a larger quantity than before as a result of which the total market demand also rises. In case of an increase in price the situation will be reserved. Thus the demand schedule reveals the inverse price-demand relationship, i.e. the Law of Demand.

Market Demand Schedule

It refers to the quantity demanded for a commodity by all the consumers in the market, within a time period.

The following example gives a demand schedule in a market consisting of only 2 consumers, Tom & Mary. Plot and name the market demand curve in the graph.

A Demand Schedule of a Market Consisted of only 2 Consumers

Price

($ per unit)

Quantity Demanded

Tom

Mary

Market (i.e. T + M)

30

2

1

3

20

4

3

7

15

6

5

11

12

8

7

15

10

10

9

19

The market demand curve is obtained by summing up the individual demand curves of the good in the market. That is, at the same price, the total quantity demanded from all consumers is added up and the value is plotted in the graph.

Law of Demand (Demand Price Relationship)

The relationship between prices and quantity demanded is called the law of demand in economics. The demand curve slopes downwards from left to right. The slope implies that price and quantity demanded are inversely related, ceteris paribus.

In other words:

An increase in the price leads to a fall in the demand and vice versa. This relationship can be stated as

Other things being equal, the demand for a commodity varies inversely as the price.

(Economics argue that they have observed the reality and found that people behave as described above according to the law. Such a common behavior is believed to be a general phenomenon of human behavior. As a result, it is regarded as a law.)

Assumptions of the Law

Income: It is assumed that there is no change in the size and distribution of individual income. If there is a change, the law will not operate. If income increases, consumer's purchasing power increases and so demand may increase even if there is a rise in price.

Tastes and Preferences: It is assumed that taste and preferences for a commodity remains unchanged and do not move in favor of new products.

Population: The size and composition of the total population in the country is assumed to be constant. If population increases, demand for commodities would increase even when prices are rising.

Price of substitutes and complementary: The price of substitutes and complimentary are assumed to be constant. If they fall in greater proportion consumer's demand for the substitute will increase and that of the commodity will decrease.

Speculation or Expectation regarding future prices: If consumers expect a further fall in the price of the commodity the demand for it would be low in the present even though its price falls. Hence, it is assumed that there should be no change in the expectations regarding future changes in prices.

Government: policy: The level of taxation and fiscal policy of the government remains the same throughout the operation of the law, otherwise changes in income tax for example may cause changes in consumer's income and as a result demand will change.

Range of goods available to the Consumers: The innovation or arrival of new variety of a product in the market may change consumer's preference, so it is assumed to be a constant one.

Weather conditions: In case of seasonal goods, a study of demand and price is made during a particular season only, for example: demand for sugarcane juice, and ice creams are made during summer season only.

Advertisements: Advertisement and publicity attracts the attention of the consumers. Due to this, there are might be changes in the consumption pattern/ so it is assumed that there is no new product introduced in the market or any new advertisement for the existing product.

Note: These Assumptions are expressed in the phrase other things remaining equal or Ceteris Paribus.

Demand Curve (DD)

It is a geometrical device to express the inverse price-demand relationship, i.e. the law of demand. A demand curve can be obtained by plotting a demand schedule on a graph and joining the points so obtained, like the demand schedule we can derive an individual demand curve as well as a market demand curve. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i.e. a market or a total demand curve. The following diagram shows the two types of demand curves.

In the above diagram, figure (A) shows an individual demand curve of any individual consumer while figure (B) indicates the total market demand. It can be noticed that both the curves are negatively sloping or downwards sloping from left to right. Such a curve shows the inverse relationship between the two variables. In this case the two variable are price on Y axis and the quantity demanded on X axis. It may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP1, the quantity demanded rises to OM1 thus a demand curve diagrammatically explains the law of demand.

Demand Function:

D = of (Price)

Or in Broader sense

D = of (P, Y, PR, A, T&P, E, O)

Determinants (Factors Affecting) of Demand

The law of demand, while explaining the price-demand relationship assumes other factors to be constant. In reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain constant and keep on affecting the demand. As a result the demand changes i.e. rises or falls, without any change in price.

Income: The relationship between income and the demand is a direct one. It means the demand changes in the same direction as the income. An increase in income leads to rise in demand and vice versa.

Population: The size of population also affects the demand. The relationship is a direct one. The higher the size of population, the higher is the demand and vice versa.

Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc. of the consumer have a profound effect on the demand for a commodity. If a consumer dislikes a commodity, he will not buy it despite a fall in price. On the other hand a very high price also may not stop him from buying a good if he likes it very much.

Other Prices: This is another important determinant of demand for a commodity. The effect depends upon the relationship between the commodities in question. If the price of a complimentary commodity rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. Opposite effect will be experienced incase of substitutes.

Advertisement: This factor has gained tremendous importance in the modern days. When a product is aggressively advertised through all the possible media, the consumers buy the advertised commodity even at a high price and many times even if they dont need it.

Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions. This factor has a great impact on the demand.

Imitation: This tendency is commonly experienced everywhere. This is known as the demonstration effects, due to which the low income groups imitate the consumption patterns of the rich ones. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries.

Exceptions of the 'Law of Demand'

In case of major bulk of the commodities the validity of the law is experienced. However there are certain situations and commodities which do not follow the law. These are termed as the exceptions to the law; these can be expressed as follows:

Continuous changes in the price lead to the exceptional behavior. If the price shows a rising trend a buyer is likely to buy more at a high price for protecting himself against a further rise. As against it when the price starts falling continuously, a consumer buys less at a low price and awaits a further in price.

Giffinss Paradox describes a peculiar experience in case of inferior goods. When the price of an inferior commodity declines, the consumer, instead of purchasing more, buys less of that commodity and switches on to a superior commodity. Hence the exception.

Demonstration Effect (Status Goods) refers to the consumption of those commodities which are bought as a matter of prestige. Naturally with a fall in the price of such goods, there is no distinction in buying the same. As a result the demand declines with a fall in the price of such prestige goods.

Effect of price rise in future If consumer knows that price of any commodity will increase in future then he will buy more quantity of the commodity at the presently increased price and store it.

Others:

Emergent Situation:

Future Expectations:

Change in Taste& Preferences and Habits

In the exceptional situations quoted above, the demand curve becomes an upwards rising one as shown in the alongside diagram. In the alongside figure, the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price.

Variation & Changes in Demand

The law of demand explains the effect of only-one factor viz., price, on the demand for a commodity, under the assumption of constancy of other determinants. In practice, other factors such as, income, population etc. cause the rise or fall in demand without any change in the price. These effects are different from the law of demand. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. In economic theory a distinction is made between (a) Variations i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and decrease in demand due to other factors.

(a) Variations in demand refer to those which occur due to changes in the price of a commodity.

These are two types.

Expansion of Demand: This refers to rise in demand due to a fall in price of the commodity. It is shown by a downwards movement on a given demand curve.

Contraction of Demand: This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve.

(b) Changes in demand imply the rise and fall due to factors other than price.

It means they occur without any change in price. They are of two types.

Increase in Demand: This refers to higher demand at the same price and results from rise in income, population etc., this is shown on a new demand curve lying above the original one.

Decrease in demand: It means less quantity demanded at the same price. This is the result of factors like fall in income, population etc. this is shown on a new demand lying below the original one.

In figure A, the original price is OP and the Quantity demanded is OQ. With a rise in price from OP to OP1 the demand contracts from OQ to OQ1 and as a result of fall in price from OP to OP2, the demand extends from OQ to OQ2.

In figure, B an increase in demand is shown by a new demand curve, D1 while the decrease in demand is expressed by the new demand curve D2, lying above and below the original demand curve D respectively. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP

Elasticity of Demand

The law of demand only explains the direction of a change as it states that with a rise in price, the demand contracts and with a fall in price, it expands. However, it fails to explain the extent or magnitude of a change in demand with a given change in price. In other words, the law of demand merely shows the direction in which the demand changes as a result of a change in price, but does not throw any light on the amount by which the demand will change in response to a given change in price. Thus, the law of demand explains the qualitative but not the quantitative aspect of price- demand relationship.

The concept of the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. It thus elaborates the price-demand relationship. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price.

According to Marshall, the elasticity (or responsiveness) of demand in a market is great or small accordingly as the demand changes (rises or falls) much or little for a given change (rise or fall) in price.

From the above definition, it is clear that though different commodities react to a change in price in the same direction; the degree of their response differs. Demand for some commodities is more elastic to a change in price, while it is less elastic for some others. Elasticity of demand is a measure of percentage changes in the quantity demanded in response to a percentage change in price. Certain goods are said to have an elastic demand while others have an inelastic demand. The demand is said to be elastic when a small change in price brings about considerable change in demand. On the other hand, the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand.

The concept of elasticity can be expressed in the form of an equation as:

Ep = [Percentage change in quantity demanded / Percentage change in the pr

Types of Elasticity:

We find four types of elasticity in practical life:

Price Elasticity of Demand,

Income Elasticity of Demand,

Cross Elasticity of Demand,

Advertising Elasticity of Demand

Now we will study each type in detail as follows:

Price Elasticity

The concept of price elasticity reveals the percentage change in quantity demanded due to the percentage change in price assuming other thing as constant (ceteris paribus). Demand for some commodities is more elastic while that for certain others are less elastic.

Types/Degrees of Price Elasticity

Using the formula of elasticity, it possible to mention following different types of price elasticity:

1) Perfectly inelastic demand (ep = 0)

2) Inelastic (less elastic) demand (e < 1)

3) Unitary elasticity (e = 1)

4) Elastic (more elastic) demand (e > 1)

5) Perfectly elastic demand (e = )

1) Perfectly inelastic demand (ep = 0)

This describes a situation in which there is no change in quantity demanded of a commodity in response to a change in price. In other words, whatever be the price, quantity demanded remains the same. It can be depicted by means of the alongside diagram.

The vertical straight line demand curve (parallel to the Y axis) as shown in Fig (a) reveals that with a change in price (from OP to Op1) the demand remains same at OQ. Thus, demand does not at all change to a change in price. Thus ep = O. Hence, it is perfectly inelastic demand.

2) Relatively Inelastic (less elastic) demand (e < 1)

In this case the proportionate change in quantity demand of a commodity is smaller than change in its price.

3) Unitary elastic demand (e = 1)

In the fig (e) percentage change in demand is smaller than that in price. It means the demand is relatively less elastic to the change in price. This is referred as relatively an inelastic demand. When the percentage change in quantity demanded is equal to percentage change in price, it is a case of unit elasticity. The rectangular hyperbola as shown in the Fig (c) represents this type of elasticity. In this case percentage change in demand is equal to percentage change in price, hence e = 1.

4) Relatively Elastic (more elastic) Demand (e > 1)

In case of certain commodities the demand is relatively more responsive to the change in price. It means a small change in price induces a significant change in, demand. This can be understood by means of the alongside figure.

It can be noticed that in the above example the percentage change in demand is greater than that in price. Hence, the elastic demand (e>1) Fig d

5) Perfectly Elastic Demand (e = )

This is experienced when the demand is extremely sensitive to the changes in price. In this case an insignificant change in price produces tremendous change in demand. The demand curve showing perfectly elastic demand is a horizontal straight line. Fig b

It can be noticed that at a given price an infinite quantity is demanded. A small change in price produces infinite change in demand. A perfectly competitive firm faces this type of demand.

From the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. In practice, however two extreme cases i.e. perfectly elastic and perfectly inelastic demand, are rarely experienced. What we really have is more elastic (e > 1) or less elastic (e < 1 ) demand. The unitary elasticity is a dividing line between these two cases.

Determinants of Elasticity

Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand. The nature of demand for a commodity depends upon this classification. The demand for necessities is inelastic and for comforts and luxuries it is elastic.

Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity of demand. The large the number of substitutes, the higher is the elastic. It means if a commodity has many substitutes, the demand will be elastic. As against this in the absence of substitutes, the demand becomes relatively inelastic because the consumers have no other alternative but to buy the same product irrespective of whether the price rises or falls.

Number of Uses: If a commodity can be put to a variety of uses, the demand will be more elastic. When the price of such commodity rises, its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses, e.g. coal electricity, water etc.

Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand for a commodity. If the consumption of a commodity can be postponed, the demand will be elastic.

Range of prices: The demand for very low-priced as well as very high-price commodity is generally inelastic. When the price is very high, the commodity is consumed only by the rich people. A rise or fall in the price will not have significant effect in the demand. Similarly, when the price is so low that the commodity can be brought by all those who wish to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand.

Proportion of Income Spent: Income of the consumer significantly influences the nature of demand. If only a small fraction of income is being spent on a particular commodity, say newspaper, the demand will tend to be inelastic.

According to Taussig, unequal distribution of income and wealth makes the demand in general, elastic.

In addition, it is observed that demand for durable goods, is usually elastic.

The nature of demand for a commodity is also influenced by the complementarities of goods.

From the above analysis of the determinants of elasticity of demand, it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. It depends upon the range of price, and the psychology of the consumers. The conclusion regarding the nature of demand should, therefore be restricted to small changes in prices during short period. By doing so, the influence of changes in habits, tastes, likes customs etc., can be ignored.

Measurement of Elasticity

For practical purposes, it is essential to measure the exact elasticity of demand. By measuring the elasticity we can know the extent to which the demand is elastic or inelastic. Different methods are used for measuring the elasticity of demand.

Percentage Method: In this method, the percentage change in demand and percentage change in price are compared.

Ep = [Percentage change in demand / Percentage change in price]

In this method, three values of ep can be obtained. Viz., ep = 1, ep > 1, ep > 1.

If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price , e = 1, it is a case of unit elasticity.

If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic.

If percentage change in demand is less than that in price, e > 1, meaning thereby the demand is inelastic.

Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller.

If a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price, ep is said to be equal to 1

If price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1.

When price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e < 1.

Another suggested by Marshall is to measure elasticity at a point on a straight line is called Point Method

Income Elasticity of Demand

The discussion of price elasticity of demand reveals that extent of change in demand as a result of change in price. However, as already explained, price is not the only determinant of demand. Demand for a commodity changes in response to a change in income of the consumer. In fact, income effect is a constituent of the price effect. The income effect suggests the effect of change in income on demand. The income elasticity of demand explains the extent of change in demand as a result of change in income. In other words, income elasticity of demand means the responsiveness of demand to changes in income. Thus, income elasticity of demand can be expressed as:

EY = [Percentage change in demand / Percentage change in income]

The following types of income elasticity can be observed:

Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than the percentage change in income, a greater portion of income is being spent on a commodity with an increase in income- income elasticity is said to be greater than one.

Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or when the percentage change in income is equal to the percentage change in demand, EY = 1 or the income elasticity is unitary.

Income Elasticity Less Than One (EY< 1): This occurs when the percentage change in demand is less than the percentage change in income.

Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does not bring about any change in the demand for a commodity.

Negative Income Elasticity of Demand (EY< o): It is well known that income effect for most of the commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income becomes negative. This implies that as the income increases the consumer, instead of buying more of a commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such cases will be negative.

Income Elasticity & Giffin Goods

Cross Elasticity of Demand

While discussing the determinants of demand for a commodity, we have observed that demand for a commodity depends not only on the price of that commodity but also on the prices of other related goods. Thus, the demand for a commodity X depends not only on the price of X but also on the prices of other commodities Y, Z.N etc. The concept of cross elasticity explains the degree of change in demand for X as, a result of change in price of Y. This can be expressed as:

EC = [Percentage Change in demand for X / Percentage change in price of Y]

The relationship between any two goods is of two types. The goods X and Y can be complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). In case of complementary commodities, the cross elasticity will be negative. This means that fall in price of X (pen) leads to rise in its demand so also rise in t) demand for Y (ink) On the other hand, the cross elasticity for substitutes is positive which means a fall in price of X (pen) results in rise in demand for X and fall in demand for Y (ball pen). If two commodities, say X and Y, are unrelated there will be no change i. Demand for X as a result of change in price of Y. Cross elasticity in cad of such unrelated goods will then be zero.

In short, cross elasticity will be of three types:

Negative cross elasticity Complementary commodities.

Positive cross elasticity Substitutes.

Zero cross elasticity Unrelated goods.

Cross Elasticity in the Case of Independent goods

Advertising Elasticity of Demand:

Good advertising will result in a positive shift in demand for a good. AED is used to measure the effectiveness of this strategy in increasing demand versus its cost.[3] Mathematically, then, AED measures the percentage change in the quantity of a good demanded induced by a given percentage change in spending on advertising in that sector:[3]

In other words, the percentage by which sales will increase after a 1% increase in advertising expenditure assuming all other factors remain equal (ceteris paribus).[2] AED is usually positive.[3] Negative advertising may, however, result in a negative AED.

Applications

AED can be used to make sure advertising expenses are in line, though an increase in demand may not be the only desired outcome of advertising.[3] The rule of thumb combines the AED with a known price elasticity of demand (PED) for the same good. The optimal relationship is denoted by:[1]

In words, "to maximize profit, the firm's advertising to sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand." Firms should advertise heavily if their AED is high (they get a lot of bang for their advertising buck) or if their PED is low (since for every added sale there is significant profit).

Thus, a comparison of PED and AED can also be used to determine whether more advertising is the correct strategy to maximise profits (e.g. for Heinz in the market for baked beans), or changing prices (as with supermarket own brands).

Importance of the concept of Elasticity

The concept of elasticity is of great importance both in economic theory and in practice.

Theoretically, its importance lies in the fact that it deeply analyses the price-demand relationship. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship.

The Pricing policy of the producer is greatly influenced by the nature of demand for his product. If the demand is inelastic, he will be benefited by charging a high price. If on the other hand, the demand is elastic, low price will be advantageous to the producer. The concept of elasticity helps the monopolist while practicing the price discrimination.

The price of joint products can be fixed on the basis of elasticity of demand. In case of such joint products, such as wool and mutton, cotton and cotton seeds, separate costs of production are not known. High price is charged for a product having inelastic demand (say cotton) and low price for its joint product having elastic demand (say cotton seeds).

The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities.

The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz., wages.

The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation, international trade etc. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue.(b) The concept of elasticity of demand helps the Government in formulating commercial policy. Protection and subsidy is granted to the industries which face an elastic demand.

The concept of elasticity of demand is very important in the field international trade. It helps in solving some of the problems of international trade such as gains from trade, balance of payments etc. policy of tariff also depends upon the nature of demand for a commodity.

In nutshell, it can be concluded that the concept of elasticity of demand has great significance in economic analysis. Its usefulness in branches of economic such as production, distribution, public finance, international trade etc., has been widely accepted.

UNIT-III

Demand Forecasting

A demand forecast is the prediction of what will happen to your company's existing product sales. It would be best to determine the demand forecast using a multi-functional approach. The inputs from sales and marketing, finance, and production should be considered. The final demand forecast is the consensus of all participating managers. You may also want to put up a Sales and Operations Planning group composed of representatives from the different departments that will be tasked to prepare the demand forecast.

Steps in Demand Forecasting

Determination of the demand forecasts is done through the following steps:

Determine the use of the forecast

Select the items to be forecast

Determine the time horizon of the forecast

Select the forecasting model(s)

Gather the data

Make the forecast

Validate and implement results

The time horizon of the forecast is classified as follows:

Description

Forecast Horizon

Type

Short-range

Medium-range

Long-range

Duration

Usually less than 3 months, maximum of 1 year

3 months to 3 years

More than 3 years

Applicability

Job scheduling, worker assignments

Sales and production planning, budgeting

New product development, facilities planning

How is demand forecast determined?

There are two approaches to determine demand forecast (1) the qualitative approach, (2) the quantitative approach. The comparison of these two approaches is shown below:

Description

Qualitative Approach

Quantitative Approach

Applicability

Used when situation is vague & little data exist (e.g., new products and technologies)

Used when situation is stable & historical data exist

(e.g. existing products, current technology)

Considerations

Involves intuition and experience

Involves mathematical techniques

Techniques

Jury of executive opinion

Sales force composite

Delphi method

Consumer market survey

Time series models

Causal models

Qualitative Forecasting Methods

Your company may wish to try any of the qualitative forecasting methods below if you do not have historical data on your products' sales.

Qualitative Method

Description

Jury of executive opinion

The opinions of a small group of high-level managers are pooled and together they estimate demand. The group uses their managerial experience, and in some cases, combines the results of statistical models.

Sales force composite

Each salesperson (for example for a territorial coverage) is asked to project their sales. Since the salesperson is the one closest to the marketplace, he has the capacity to know what the customer wants. These projections are then combined at the municipal, provincial and regional levels.

Delphi method

A panel of experts is identified where an expert could be a decision maker, an ordinary employee, or an industry expert. Each of them will be asked individually for their estimate of the demand. An iterative process is conducted until the experts have reached a consensus.

Consumer market survey

The customers are asked about their purchasing plans and their projected buying behavior. A large number of respondents is needed here to be able to generalize certain results.

Quantitative Forecasting Methods

There are two forecasting models here (1) the time series model and (2) the causal model. A time series is a set of evenly spaced numerical data and is obtained by observing responses at regular time periods. In the time series model, the forecast is based only on past values and assumes that factors that influence the past, the present and the future sales of your products will continue.

On the other hand, t he causal model uses a mathematical technique known as the regression analysis that relates a dependent variable (for example, demand) to an independent variable (for example, price, advertisement, etc.) in the form of a linear equation. The time series forecasting methods are described below:

Time Series Forecasting Method

Description

Nave Approach

Assumes that demand in the next period is the same as demand in most recent period; demand pattern may not always be that stable

For example:

If July sales were 50, then Augusts sales will also be 50

Time Series Forecasting Method

Description

Moving Averages (MA)

MA is a series of arithmetic means and is used if little or no trend is present in the data; provides an overall impression of data over time

A simple moving average uses average demand for a fixed sequence of periods and is good for stable demand with no pronounced behavioral patterns.

Equation:

F 4 = [D 1 + D2 + D3] / 4

F forecast, D Demand, No. Period

(see illustrative example simple moving average)

A weighted moving average adjusts the moving average method to reflect fluctuations more closely by assigning weights to the most recent data, meaning, that the older data is usually less important. The weights are based on intuition and lie between 0 and 1 for a total of 1.0

Equation:

WMA 4 = (W) (D3) + (W) (D2) + (W) (D1)

WMA Weighted moving average, W Weight, D Demand, No. Period

(see illustrative example weighted moving average)

Exponential Smoothing

The exponential smoothing is an averaging method that reacts more strongly to recent changes in demand by assigning a smoothing constant to the most recent data more strongly; useful if recent changes in data are the results of actual change (e.g., seasonal pattern) instead of just random fluctuations

F t + 1 = a D t + (1 - a ) F t

Where

F t + 1 = the forecast for the next period

D t = actual demand in the present period

F t = the previously determined forecast for the present period

= a weighting factor referred to as the smoothing constant

(see illustrative example exponential smoothing)

Time Series Decomposition

The time series decomposition adjusts the seasonality by multiplying the normal forecast by a seasonal factor

(see illustrative example time series decomposition)

Production Function:

A given output can be produced with many different combinations of factors of production (land, labor, capita! and organization) or inputs. The output, thus, is a function of inputs. The functional relationship that exists between physical inputs and physical output of a firm is called production function.

Formula:

In abstract term, it is written in the form of formula:

Q = f (x1, x2, ......., xn)

Q is the maximum quantity of output and x1, x2, xn are quantities of various inputs. The functional relationship between inputs and output is governed by the laws of returns.

The laws of returns are categorized into two types.

(i) The law of variable proportion seeking to analyze production in the short period.

(ii) The law of returns to scale seeking to analyze production in the long period.

Law of Variable Proportions/Law of Non Proportional Returns/Law of Diminishing Returns:(Short Run Analysis of Production):

There were three laws of returns mentioned in the history of economic thought up till Alfred Marshall's time. These laws were the laws of increasing returns, diminishing returns and constant returns. Dr. Marshall was of the view that the law of diminishing returns applies to agriculture and the law of increasing returns to industry. Much time was wasted in discussion of this issue. However, it was later on recognized that there are not three laws of production. It is only one law of production which has three phases, increasing, diminishing and negative production. This general law of production was named as the Law of Variable Proportions or the Law of Non-Proportional Returns.

The Law of Variable Proportions which is the new name of the famous law of Diminishing Returns has been defined by Stigler in the following words:

"As equal increments of one input are added, the inputs of other productive services being held constant, beyond a certain point, the resulting increments of produce will decrease i.e., the marginal product will diminish".

According to Samuelson:"An increase in some inputs relative to other fixed inputs will in a given state of technology cause output to increase, but after a point, the extra output resulting from the same addition of extra inputs will become less".

Assumptions:

The law of variable proportions also called the law of diminishing returns holds good under the following assumptions:

Short run: The law assumes short run situation. The time is too short for a firm to change the quantity of fixed factors. All the, resources apart from this one variable, are held unchanged in quantity and quality.

Constant technology: The law assumes that the technique of production remains unchanged during production.

Homogeneous factors: Each factor unit in assumed to he identical in amount and quality.

Explanation and Example:

The law of variable proportions is, now explained with the help of table and graph.

Fixed Inputs (Land Capital)

Variable Resource (labor)

Total Produce (TP Quintals)

Marginal Product (MP Quintals)

Average Product (AP Quintals)

30

30

1

2

10

25

10

15

Increasing marginal return

10

12.5

30

30

30

30

30

3

4

5

6

7

37

47

55

60

63

12

10

8

5

3

Diminishing marginal returns

12.3

11.8

11.0

10.0

9.0

30

30

8

9

63

62

0

-1

Negative marginal returns

7.9

6.8

In the table above, it is assumed that a farmer has only 30 acres of land for cultivation. The investment on it in the form of tube wells, machinery etc., (capital) is also fixed. Thus land and capital with the farmer is fixed and labor is the variable resource.

As the farmer increases units of labor from one to two to the amount of other fixed resources (land and capital), the marginal as well as average product increases. The total product also increase at an increasing rate from 10 to 25 quintals. It is the stage of increasing returns.

The stage of increasing returns with the employment of more labor does not last long. It is shown in the table that with the employment of 3rd labor at the farm, the marginal product and the average product (AP) both fall but marginal product (MP) falls more speedily than the average product AP). The fall in MP and AP continues as more men are put on the farm.

The decrease, however, remains positive up to the 7th labor employed. On the employment of 7th worker, the total production remains constant at 63 quintals. The marginal product is zero. if more men are employed the marginal product becomes negative. It is the stage of negative returns. We here find the behavior of marginal product (MP). it shows three stages. In the first stage, it increases, in the 2nd it continues to fall and in the 3rd stage it becomes negative.

Three Stages of the Law:

There are three phases or stages of production, as determined by the law of variable proportions:

Increasing returns.

Diminishing returns.

Negative returns.

Diagram/Graph:

These stages can be explained with the help of graph below:

(i) Stage of Increasing Returns. The first stage of the law of variable proportions is generally called the stage of increasing returns. In this stage as a variable resource (labor) is added to fixed inputs of other resources, the total product increases up to a point at an increasing rate as is shown in figure 11.1.

The total product from the origin to the point K on the slope of the total product curve increases at an increasing rate. From point K onward, during the stage II, the total product no doubt goes on rising but its slope is declining. This means that from point K onward, the total product increases at a diminishing rate. In the first stage, marginal product curve of a variable factor rises in a part and then falls. The average product curve rises throughout .and remains below the MP curve.

Causes of Initial Increasing Returns:

The phase of increasing returns starts when the quantity of a fixed factor is abundant relative to the quantity of the variable factor. As more and more units of the variable factor are added to the constant quantity of the fixed factor, it is more intensively and effectively used. This causes the production to increase at a rapid rate. Another reason of increasing returns is that the fixed factor initially taken is indivisible. As more units of the variable factor are employed to work on it, output increases greatly due to fuller and effective utilization of the variable factor.

(ii) Stage of Diminishing Returns. This is the most important stage in the production function. In stage 2, the total production continues to increase at a diminishing rate until it reaches its maximum point (H) where the 2nd stage ends. In this stage both the

marginal product (MP) and average product of the variable factor are diminishing but are positive.

Causes of Diminishing Returns:

The 2nd phase of the law occurs when the fixed factor becomes inadequate relative to the quantity of the variable factor. As more and more units of a variable factor are employed, the marginal and average product decline. Another reason of diminishing returns in the production function is that the fixed indivisible factor is being worked too hard. It is being used in non-optima! proportion with the variable factor, Mrs. J. Robinson still goes deeper and says that the diminishing returns occur because the factors of production are imperfect substitutes of one another.

(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP, curve slopes downward (From point H onward). The MP curve falls to zero at point L2 and then is negative. It goes below the X axis with the increase in the use of variable factor (labor).

Causes of Negative Returns:

The 3rd phases of the law starts when the number of a variable, factor becomes, too excessive relative, to the fixed factors, A producer cannot operate in this stage because total production declines with the employment of additional labor.

a rational producer will always seek to produce in stage 2 where MP and AP of the variable factor are diminishing. At which particular point, the producer will decide to produce depends upon the price of the factor he has to pay. The producer will employ the variable factor (say labor) up to the point where the marginal product of the labor equals the given wage rate in the labor market.

Importance:

The law of variable proportions has vast general applicability. Briefly:

(i) It is helpful in understanding clearly the process of production. It explains the input output relations. We can find out by-how much the total product will increase as a result of an increase in the inputs.

(ii) The law tells us that the tendency of diminishing returns is found in all sectors of the economy which may be agriculture or industry.

(iii) The law tells us that any increase in the units of variable factor will lead to increase in the total product at a diminishing rate. The elasticity of the substitution of the variable factor for the fixed factor is not infinite.

From the law of variable proportions, it may not be understood that there is no hope for raising the standard of living of mankind. The fact, however, is that we can suspend the operation of diminishing returns by continually improving the technique of production through the progress in science and technology.

Law of Diminishing Returns/Law of Increasing Cost:

The law of diminishing returns (also called the Law of Increasing Costs) is an important law of micro economics. The law of diminishing returns states that:

"If an increasing amounts of a variable factor are applied to a fixed quantity of other factors per unit of time, the increments in total output will first increase but beyond some point, it begins to decline".

Richard A. Bilas describes the law of diminishing returns in the following words:

"If the input of one resource to other resources are held constant, total product (output) will increase but beyond some point, the resulting output increases will become smaller and smaller".

The law of diminishing return can be studied from two points of view, (i) as it applies to agriculture and (ii) as it applies in the field of industry.

(1) Operation of Law of Diminishing Returns in Agriculture:

Traditional Point of View. The classical economists were of the opinion that the taw of diminishing returns applies only to agriculture and to some extractive industries, such as mining, fisheries urban land, etc. The law was first stated by a Scottish farmer as such. It is the practical experience of every farmer that if he wishes to raise a large quantity of food or other raw material requirements of the world from a particular piece of land, he cannot do so. He knows it fully that the producing capacity of the soil is limited and is subject to exhaustation.

As he applies more and more units of labor to a given piece of land, the total produce no doubt increases but it increases at a diminishing rate.

For example, if the number of labor is doubled, the total yield of his land will not be double. It will be less than double. If it becomes possible to increase the. yield in the very same ratio in which the units of labor are increased, then the raw material requirements of the whole world can be met by intensive cultivation in a single flower-pot. As this is not possible, so a rational farmer increases the application of the units of labor on a piece of land up to a point which is most profitable to him. This is in brief, is the law of diminishing returns. Marshall has stated this law as such:

"As Increase in capital and labor applied to the cultivation of land causes in general a less than proportionate increase in the amount of the produce raised, unless it happens to coincide with the improvement in the act of agriculture".

Explanation and Example:

This law can be made more clear if we explain it with the help, of a schedule and a curve.

Fixed Input

Inputs of Variable Resources

Total Produce TP (in tons)

Marginal product MP (in tons)

12 Acres

12 Acres

12 Acers

12 Acres

12 Acers

12 Acres

1 Labor

2 Labor

3 Labor

4 Labor

5 Labor

6 Labor

50

120

180

200

200

195

50

70

60

20

0

-5

In the schedule given above, a firm first cultivates 12 acres of land (Fixed input) by applying one unit of labor and produces 50 tons of wheat.. When it applies 2 units of labor, the total produce increases to 120 tons of wheat, here, the total output increased to more than double by doubling the units of labor. It is because the piece of land is under-cultivated. Had he applied two units of labor in the very beginning, the marginal return would have diminished by the application of second unit of labor.

In our schedules the rate of return is at its maximum when two units of labor are applied. When a third unit of labor is employed, the marginal return comes down to 60 tons of wheat With the application of 4th unit. the marginal return goes down to 20 tons of wheat and when 5th unit is applied it makes no addition to the total output. The sixth unit decreased it. This tendency of marginal returns to diminish as successive units of a variable resource (labor) are added to a fixed resource (land), is called the law of diminishing returns. The above schedule can be represented graphically as follows:

Diagram/Graph:

In Fig. (11.2) along OX are measureddoses of labor applied to a piece of land and along OY, the marginal return. In the beginning the land was not adequately cultivated, so the additional product of the second unit increased more than of first. When 2 units of labor were applied, the total yield was the highest and so was the marginal return. When the number of workers is increased from 2 to 3 and more. the MP begins to decrease. As fifth unit of labor was applied, the marginal return fell down to zero and then it decreased to 5 tons.

Assumptions:

The table and the diagram is based on the following assumptions:

(i) The time is too short for a firm to change the quantity of fixed factors.

(ii) It is assumed that labor is the only variable factor. As output increases, there occurs no change in the factor prices.

(iii) All the units of the variable factor are equally efficient.

(iv) There are no changes in the techniques of production.

(2) Operation of the Law in the Field of Industry:

The modern economists are of the opinion that the law of diminishing returns is not exclusively confined to agricultural sector, but it has a much wider application. They are of the view that whenever the supply of any essential factor of production cannot be increased or substituted proportionately with the other sectors, the return per unit of variable factor begins to decli