The Scopes Economics Are Mentions Bellow

Economics For Managerial Decision Making -2 |1 The scopes Economics are mentions bellow Study of human affair: The aim of economics is to study human activities which are conductive to human affair. Study of economics helps to search for the ways to fulfill human needs by limited products. Deals with economic activities: Economics is concern with such activities as relate to acquiring wealth & spending wealth. These twos are twos corner-stones of economics. Deals with production, consumption distribution & exchange: Economics focus on different activities like as production, consumption & distribution. Economic instruments like as money, tax, interest rateare necessary for production, consumption, exchange & distribution. Meet unlimited wants with limited resources: Human want is unlimited. But the resources are limited. Economics helps to meet unlimited wants by using alternative resources. Economics is the study of how people can distribute their limited resources to produce & consume goods to satisfy their wants & maximize their utilities. Deals with domestic & international trade: To solve economic problems: The basic 3 problems of economics are what to produce, how to produce & for whom to produce. In order to use the limited resources efficiently & provide opportunities & systematic ways economics studies. Thats why economics has to tackle these fundamental problems. Market economy: Economics deals with demand, supply & balance of market. It determines price of & quantities of commodities. Science of welfare: It deals with mankind & individual society & even state. This fact is clear from the definition of Alfred Marshall. Positive science: What is happening in an economy that are discussed by positive economics & based on the current events & positive economist can calculate about the future. Normative science: All the concurrent events arent beneficial for the society. Normative economists discuss about the facts that are beneficial for the society Economics as a tool for decision making : Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Following are the various steps in decision making process: 1. Establish objectives 2. Specify the decision problem 3. Identify the alternatives 4. Evaluate alternatives 5. Select the best alternatives 6. Implement the decision 7. Monitor the performance Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal. Basic economic tools in managerial economics for decision making: Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision. Following are the basic economic tools for decision making: 1. Opportunity cost 2. Incremental principle

Economics For Managerial Decision Making -2 |23. Principle of the time perspective 5. Equi-marginal principle 4. Discounting principle

1) Opportunity cost principle: By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g. a) The opportunity cost of the funds employed in ones own business is the interest that could be earned on those funds if they have been employed in other ventures. b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank. Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs. 2) Incremental principle: It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions. The two basic components of incremental reasoning are 1. Incremental cost 2. Incremental Revenue The incremental principle may be stated as under: A decision is obviously a profitable one if it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues 3) Principle of Time Perspective Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations. For example; Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to managements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long run repercussion of the order is to be taken into account: 1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. 2) If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.

Economics For Managerial Decision Making -2 |3In the above example it is therefore important to give due consideration to the time perspectives. a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective. 4) Discounting Principle: One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasonsi) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108 5) Equi marginal Principle: This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle. Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities. Managerial Economics: Definition and Scope Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial Economics. Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms. Definition of Managerial Economics: Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul. Business Economics consists of the use of economic modes of thought to analyse business situations.McNair and Meriam Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. Spencerand Seegelman. Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision. Mansfield Nature of Managerial Economics: The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken.

Economics For Managerial Decision Making -2 |4 The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go on at the same time. A business managers task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decisionmaking through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art. Scope of Managerial Economics: The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics: 1. Demand Analysis and Forecasting 2. Cost and Production Analysis 3. Pricing Decisions, Policies and Practices 4. Profit Management 5. Capital Management These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics. 1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.

Economics For Managerial Decision Making -2 |52. Cost and production analysis: A firms profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control. 3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting. 4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of Managerial Economics. 5. Capital management: The problems relating to firms capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects. Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of Managerial Economics consists of applying economic principles and concepts towards adjusting with various uncertainties faced by a business firm. Difference between Economics and Managerial Economics: 1) Managerial Economics is micro in character Pure Economics is both micro and macro in character 2) Managerial Economics study only practical application of the Economic principle to the problem of firm Pure Economics deals with the study of principles itself 3) Managerial Economics deals with the Economic problems of the firm while Pure Economics deals with Economic problems of both firm and individuals 4) Managerial Economics deals with profit theory only Pure Economics deals with all distribution theories like rent, wages, interests, and profits.

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Nature of Managerial EconomicsManagerial Economics and Business economics are the two terms, which, at times have been used interchangeably. Of late, however, the term Managerial Economics has become more popular and seems to displace progressively the term Business Economics. The prime function of a management executive in a business organization is decision making and forward planning. Decision Making means the process of selecting one action from two or more alternative courses of action whereas forward planning means establishing plans for the future. The question of choice arises because resources such as capital, land, labourand management are limited and can be employed in alternative uses. The decision making function thus becomes one of making choices or decisions that will provide the most efficient means of attaining a desired end, say, profit maximization. Once decision is made about the particular goal to be achieved, plans as to production, pricing, capital, raw materials, labour, etc., are prepared. Forward planning thus goes hand in hand with decision making. A significant characteristic of the conditions, in which business organizations work and take decisions, is uncertainty. And this fact of uncertainty not only makes the function of decision making and forward planning complicated but adds a different dimension to it. If knowledge of the future were perfect, plans could be formulated without error and hence without any need for subsequent revision. In the real world, however, the business manager rarely has complete information and the estimates about future predicted as best as possible. As plans are implemented over time, more facts become known so that in their light, plans may have to be revised, and a different course of action adopted. Managers are thus engaged in a continuous process of decision making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision making in an uncertainty framework, economic theory can be pressed into service with considerable advantage. Economic theory deals with a number of concepts and principles relating, for example, to profit, demand, cost, pricing production, competition, business cycles, national income, etc., which aided by allied disciplines like Accounting. Statistics and Mathematics can be used to solve or at least throw some light upon the problems of business management. The way economic analysis can be used towards solving business problems. Constitutes the subject matter of Managerial Economics.

Definition of Managerial EconomicsAccording to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought to analyse business situation." Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management." We may, therefore define Managerial Economics as the discipline which deals with the application of economic theory to business management. Managerial Economics thus lies on the borderline between economics and business management and serves as a bridge between economics and business management. Chart 1 Economics, Business Management and Managerial Economics.

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Application of Economics to Business ManagementThe application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects :1. Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions. In economic theory, the technique of analysis is one of model building whereby certain assumptions are made and on that basis, conclusions as to the behavior of the firms are drown. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of that what the firms actually do. Hence the need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develops appropriate extensions and reformulation of economic theory, if necessary. 2. Estimating economic relationships, viz., measurement of various types of elasticities of demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity, cost-output relationships, etc. The estimates of these economic relationships are to be used for purposes of forecasting. 3. Predicting relevant economic quantities, eg., profit, demand, production, costs, pricing, capital, etc., in numerical terms together with their probabilities. As the business manager has to work in an environment of uncertainty, future is to be predicted so that in the light of the predicted estimates, decision making and forward planning may be possible. 4. Using economic quantities in decision making and forward planning, that is, formulating business policies and, on that basis, establishing business plans for the future pertaining to profit, prices, costs, capital, etc. The nature of economic forecasting is such that it indicates the degree of probability of various possible outcomes, i.e. losses or gains as a result of following each one of the strategies available. Hence, before a business manager there exists a quantified picture indicating the number o courses open, their possible outcomes and the quantified probability of each outcome. Keeping this picture in view, he decides about the strategy to be chosen. 5. Understanding significant external forces constituting the environment in which the business is operating and to which it must adjust, e.g., business cycles, fluctuations in national income and government policies pertaining to public finance, fiscal policy and taxation, international economics and foreign trade, monetary economics, labour relations, anti-monopoly measures, industrial licensing, price controls, etc. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.

Characteristics of Managerial Economics

Economics For Managerial Decision Making -2 |8It would be useful to point out certain chief characteristics of Managerial Economics, in as much its they throw further light on the nature of the subject matter and help in a clearer understanding thereof. 1. Managerial Economics is micro-economic in character. 2. Managerial Economics largely uses that body of economic concepts and principles, which is known as 'Theory of the firm' or 'Economics of the firm'. In addition, it also seeks to apply Profit Theory, which forms part of Distribution Theories in Economics. 3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but involves complications ignored in economic theory to face the overall situation in which decisions are made. Economic theory appropriately ignores the variety of backgrounds and training found in individual firms but Managerial Economics considers the particular environment of decision making. 4. Managerial Economics belongs to normative economics rather than positive economics (also sometimes known as Descriptive Economics). In other words, it is prescriptive rather than descriptive. The main body of economic theory confines itself to descriptive hypothesis, attempting to generalize about the relations among different variables without judgment about what is desirable or undesirable. For instance, the law of demand states that as price increases. Demand goes down or vice-versa but this statement does not tell whether the outcome is good or bad. Managerial Economics, however, is concerned with what decisions ought to be made and hence involves value judgments. Production and Supply Production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with different production functions and their managerial uses. Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are supply schedule, curves and function, law of supply and its limitations. Elasticity of supply and Factors influencing supply. Pricing Decisions, Policies and Practices Pricing is a very important area of Managerial Economics. In fact, price is the ness of the revenue of a firm and as such the success of a business firm largely depends on the correctness of the prices decisions taken by it. The important aspects dealt with under this area are :- Price Determination in various Market Forms, Pricing methods, Differential Pricing, Product-line Pricing and Price Forecasting. Profit Management Business firms are generally organized for the purpose of making profits and, in long run, profits provide the chief measure of success. In this connection, an important point worth considering is the element of uncertainty exiting about profits because of variations in costs and revenues which, in turn, are caused by torso both internal and external to the firm. If knowledge about the future were fact, profit analysis would have been a very easy task. However, in a world of certainty, expectations are not always realized so that profit planning and measurement constitute the difficult are of Managerial Economics. The important acts covered under this area are :- Nature and Measurement of Profit, Profit Testing and Techniques of Profit Planning like Break-Even Analysis. Capital Management Of the various types and classes of business problems, the most complex and able some for the business manager are likely to be those relating to the firms investments. Relatively large sums are involved, and the problems are so complex that their disposal not only requires considerable time and labour but is a term for top-level decision. Briefly, capital management implies planning and trolls of capital expenditure. The main topics dealt with are :- Cost of Capital, Rate return and Selection of Project.

Economics For Managerial Decision Making -2 |9The various aspects outlined above represent the major uncertainties which a ness firm has to reckon with, viz., demand uncertainty, cost uncertainty, price certainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude the subject matter of Managerial Economic consists of applying economic cripples and concepts towards adjusting with various uncertainties faced by a ness firm.

Managerial Economics and Other SubjectsYet another useful method of throwing light upon the nature and scope of Managerial Economics is to examine its relationship with other subjects. In this connection, Economics, Statistics, Mathematics and Accounting deserve special mention. Managerial Economics and Economics Managerial Economics has been described as economics applied to decision making. It may be viewed as a special branch of economics bridging the gulf between pure economic theory and managerial practice. Economics has two main divisions :- (i) Microeconomics and (ii) Macroeconomics. Microeconomics has been defined as that branch of economics where the unit of study is an individual or a firm. Macroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit of study. Microeconomics, also known as price theory (or Marshallian economics) is the main source of concepts and analytical tools for managerial economics. To illustrate various micro-economic concepts such as elasticity of demand, marginal cost, the short and the long runs, various market forms, etc., all are of great significance to managerial economics. The chief contribution of macroeconomics is in the area of forecasting. The modern theory of income and employment has direct implications for forecasting general business conditions. As the prospects of an individual firm often depend greatly on general business conditions, individual firm forecasts depend on general business forecasts. A survey in the U.K has shown that business economists have found the following economic concepts quite useful and of frequent application :1. Price elasticity of demand, 2. Income elasticity of demand, 3. Opportunity cost, 4. The multiplier, 5. Propensity to consume, 6. Marginal revenue product, 7. Speculative motive, 8. Production function, 9. Balanced growth, and 10. Liquidity preference. Business economics have also found the following main areas of economics as useful in their work :1. Demand theory, 2. Theory of the firm-price, output and investment decisions, 3. Business financing, 4. Public finance and fiscal policy, 5. Money and banking, 6. National income and social accounting, 7. Theory of international trade, and 8. Economics of developing countries.

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 10Managerial Economics and Management Accounting Managerial Economics is also closely related to accounting, which is concerned with recording the financial operations of a business firm. Indeed, accounting information is one of the principal sources of data required by a managerial economist for his decision making purpose. For instance, the profit and loss statement of a firm tells how well the firm has done and the information it contains can be used by managerial economist to throw significant light on the future course of action - whether it should improve or close down. Of course, accounting data call for careful interpretation. Recasting and adjustment before they can be used safely and effectively. It is in this context that the growing link between management accounting and managerial economics deserves special mention. The main task of management accounting is now seen as being to provide the sort of data which managers need if they are to apply the ideas of managerial economics to solve business problems correctly; the accounting data are also to be provided in a form so as to fit easily into the concepts and analysis of managerial economics.

Uses of Managerial EconomicsManagerial economics accomplishes several objectives. First, it presents those aspects of traditional economics, which are relevant for business decision making it real life. For the purpose, it calls from economic theory the concepts, principles and techniques of analysis which have a bearing on the decision making process. These are, if necessary, adapted or modified with a view to enable the manager take better decisions. Thus, managerial economics accomplishes the objective of building suitable tool kit from traditional economics. Secondly, it also incorporates useful ideas from other disciplines such a psychology, sociology, etc., if they are found relevant for decision making. In fact managerial economics takes the aid of other academic disciplines having a bearing upon the business decisions of a manager in view of the carious explicit and implicit constraints subject to which resource allocation is to be optimized. Thirdly, managerial economics helps in reaching a variety of business decisions. 1. What products and services should be produced? 2. What inputs and production techniques should be used? 3. How much output should be produced and at what prices it should be sold? 4. What are the best sizes and locations of new plants? 5. How should the available capital be allocated? Fourthly, managerial economics makes a manager a more competent model builder. Thus he can capture the essential relationships which characterize a situation while leaving out the cluttering details and peripheral relationships. Fifthly, at the level of the firm, where for various functional areas functional specialists or functional departments exist, e.g., finance, marketing, personal production, etc., managerial economics serves as an integrating agent by coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas. It thus enables business decision making not in watertight compartments but in an integrated perspective, the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting coals. Finally, managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be realized that business part from its obligations to shareholders has certain social obligations. Managerial economics focuses attention on these social obligations as constraints subject to which business decisions are to be taken. In so doing, it serves as an instrument in rehiring the economic welfare of the society through socially oriented business decisions.

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Role and Responsibilities of Managerial EconomistA managerial economist can play a very important role by assisting the Management in using the increasingly specialized skills and sophisticated techniques which are required to solve the difficult problems of successful decision making and forward planning. That is why, in business concerns, his importance is being growingly recognized. In developed countries like the U.S.A., large companies employ one or more economists. In our country (India) too, big industrial houses have come to recognize the need for managerial economists, and there are frequent advertisements for such positions. Tatas and Hindustan Lever employ economists. Indian Petrochemicals Corporation Ltd., a Government of India undertaking, also keeps an economist. Let us examine in specific terms how a managerial economist can contribute to decision making in business. In this connection, two important questions need be considered :1. What role does he play in business, that is, what particular management problems lend themselves to solution through economic analysis? 2. How can the managerial economist best serve management, that is, what are the responsibilities of a successful managerial economist?

Role of Managerial EconomistOne of the principal objectives of any management in its decision making process is to determine the key factors which will influence the business over the period ahead. In general, these factors can be divided into two category, viz., (i) External and (ii) Internal. The external factors lie outside the control management because they are external to the firm and are said to constitute business environment. The internal factors lie within the scope and operations of a firm and hence within the control of management, and they are known as business operations. To illustrate, a business firm is free to take decisions about what to invest, where to invest, how much labour to employ and what to pay for it, how to price its products and so on but all these decisions are taken within the framework of a particular business environment and the firms degree of freedom depends on such factors as the governments economic policy, the actions of its competitors and the like.

Environmental Studies An analysis and forecast of external factors constituting general business conditions, e.g., prices, national income and output, volume of trade, etc., are of great significance since every business from is affected by them. Certain important relevant questions in this connection are as follows :1. What is the outlook for the national economy? What are the most important local, regional or worldwide economic trends? What phase of the business cycle lies immediately ahead? 2. What about population shifts and the resultant ups and downs in regional purchasing power? 3. What are the demands prospects in new as well as established markets? Will changes in social behavior and fashions tend to expand or limit the sales of a companys products, or possibly make the products obsolete? 4. Where are the market and customer opportunities likely to expand or contract most rapidly? 5. Will overseas markets expand or contract, and how will new foreign government legislations affect operation of the overseas plants? 6. Will the availability and cost of credit tend to increase or decrease buying? Are money or credit conditions ahead likely to be easy or tight? 7. What the prices of raw materials and finished products are likely to be?

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 128. Is competition likely to increase or decrease? 9. What are the main components of the five-year plan? What are the areas where outlays have been increased? What are the segments, which have suffered a cut in their outlay? 10. What is the outlook regarding governments economic policies and regulations? 11. What about changes in defense expenditure, tax rates, tariffs and import restrictions? 12. Will Reserve Banks decisions stimulate or depress industrial production and consumer spending? How will these decisions affect the companys cost, credit, sales and profits? Reasonably accurate answers to these and similar questions can enable management to chalk out more wisely the scope and direction of their own business plans and to determine the timing of their specific actions. And it is these questions which present some of the areas where a managerial economist can make effective contribution. The managerial economist has not only to study the economic trends at the macro level but must also interpret their relevance to the particular industry / firm where he works. He has to digest the ever growing economic literature and advise top management by means of short, business like practical notes. In a mixed economy like India, the managerial economist pragmatically interprets the intentions of controls and evaluates their impact. He acts as a bridge between the government and the industry, translating the governments intentions and transmitting the reactions of the industry. In fact, government policies charge out of the performance of industry, the expectations of the people and political expediency. Business Operations A managerial economist can also be helpful to the management in making decisions relating to the internal operations of a firm in respect of such problems as price, rate of operations, investment, expansion or contraction. Certain relevant questions in this context would be as follows :1. What will be a reasonable sales and profit budget for the next year? 2. What will be the most appropriate production Schedules and inventory policies for the next six months? 3. What changes in wage and price policies should be made now? 4. How much cash will be available next month and how should it be invested? Specific Functions A further idea of the role of managerial economists can be seen from the following specific functions performed by them as revealed by a survey pertaining to Britain conducted by K.J.W. Alexander and Alexander G. Kemp :1. Sales forecasting. 2. Industrial market research. 3. Economic analysis of competing companies. 4. Pricing problems of industry. 5. Capital projects. 6. Production programs. 7. Security/investment analysis and forecasts. 8. Advice on trade and public relations. 9. Advice on primary commodities. 10. Advice on foreign exchange. 11. Economic analysis of agriculture. 12. Analysis of underdeveloped economics. 13. Environmental forecasting.

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 13The managerial economist has to gather economic data, analyze all pertinent information about the business environment and prepare position papers on issues facing the firm and the industry. In the case of industries prone to rapid technological advances, he may have to make a continuous assessment of the impact of changing technology. He may have to evaluate the capital budget in the light of short and long-range financial, profit and market potentialities. Very often, he may have to prepare speeches for the corporate executives. It is thus clear that in practice managerial economists perform many and varied functions. However, of these, marketing functions, i.e., sales forecasting and industrial market research, has been the most important. For this purpose, they may compile statistical records of the sales performance of their own business and those relating to their rivals, carry our analysis of these records and report on trends in demand, their market shares, and the relative efficiency of their retail outlets. Thus while carrying out their functions; they may have to undertake detailed statistical analysis. There are, of course, differences in the relative importance of the various functions performed from firm to firm and in the degree of sophistication of the methods used in carrying them out. But there is no doubt that the job of a managerial economist requires alertness and the ability to work under pressure. Economic Intelligence Besides these functions involving sophisticated analysis, managerial economist may also provide general intelligence service supplying management with economic information of general interest such as competitors prices and products, tax rates, tariff rates, etc. In fact, a good deal of published material is already available and it would be useful for a firm to have someone who understands it. The managerial economist can do the job with competence. Participating in Public Debates Many well-known business economists participate in public debates. Their advice and views are being sought by the government and society alike. Their practical experience in business and industry ads stature to their views. Their public recognition enhances their stature in the organization itself. Indian Context In the indian context, a managerial economist is expected to perform the following functions :1. Macro-forecasting for demand and supply. 2. Production planning at macro and micro levels. 3. Capacity planning and product-mix determination. 4. Economics of various productions lines. 5. Economic feasibility of new production lines/processes and projects. 6. Assistance in preparation of overall development plans. 7. Preparation of periodical economic reports bearing on various matters such as the companys product-lines, future growth opportunities, market pricing situation, general business, and various national/international factors affecting industry and business. 8. Preparing briefs, speeches, articles and papers for top management for various Chambers, Committees, Seminars, Conferences, etc. 9. Keeping management informed o various national and international developments on economic/industrial matters. With the adoption of the New Economic Policy, in 1991, the macro-economic Environment in India is changing fast at a pace that has been rarely witnessed before. And these changes have tremendous implications for business. The managerial economist has to play a much more significant role. He has to constantly gauge the possibilities of translating the rapidly changing economic scenario into viable business opportunities. As India

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 14marches towards globalization, he will have to interpret the global economic events and find out how his firm can avail itself of the carious export opportunities or of establishing plants abroad either wholly owned or in association with local partners.

Responsibilities of Managerial EconomistHaving examined the significant opportunities before a managerial economist to contribute to managerial decision making, let us now examine how he can best serve the management. For this, he must thoroughly recognize his responsibilities and obligations. A managerial economist can serve management best only if he always keeps in mind the main objective of his business, viz., to make a profit on its invested capital. His academic training and the critical comments from people outside the business may lead a managerial economist to adopt an apologetic or defensive attitude towards profits. Once management notices this, his effectiveness is almost sure to be lost. In fact, he cannot expect to succeed in serving management unless he has a strong personal conviction that profits are essential and that his chief obligation is to help enhance the ability of the firm to make profits. Most management decisions necessarily concern the future, which is rather uncertain. It is, therefore, absolutely essential that a managerial economist recognizes his responsibility to make successful forecasts. By making best possible forecasts and through constant efforts to improve upon them, he should aim at minimizing, if not completely eliminating, the risks involved in uncertainties, so that the management can follow a more orderly course of business planning. At times, he will have to reassure the management that an important trend will continue; in other cases, he may have to point out the probabilities of a turning point in some activity of importance to management. In any case, he must be willing to make considered but fairly positive statements about impending economic developments, based upon the best possible information and analysis and stake his reputation upon his judgment. Nothing will build management confidence in a managerial economist more quickly and thoroughly than a record of successful forecasts, well-documented in advance and modestly evaluated when the actual results become available. A few corollaries to the above proposition need also be emphasized here. First, he has a major responsibility to "alert management at the earliest possible moment" in case he discovers an error in his forecast. By promptly drawing attention to changes in forecasting conditions, he will not only assist management in making appropriate adjustment in policies and programs but will also be able to strengthen his own position as a member of the management team by keeping his fingers on the economic pulse of the business. Secondly, he must establish and maintain many contacts with individuals and data sources, which would not be immediately available to the other members of the management. Extensive familiarity with reference sources and material is essential, but it is still more important that he knows individuals who are specialists in particular fields having a bearing on his work. For this purpose, he should join professional associations and take active part in them. In fact, one of the best means of determining the caliber of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources. Within any business, there may be a wealth of knowledge and experience but the managerial economist would be really useful if he can supplement the existing know-how with additional information and in the quickest possible manner. Again, if a managerial economist is to be really helpful to the management in successful decision making and forward planning, he must be able to earn full status on the business team. He should be ready and even offer himself to take up special assignments, be that in study teams, committees or special projects. For, a managerial economist can only function effectively in an atmosphere where his success or failure can be traced not only to his basic ability, training and experience, but also to his personality and capacity to win continuing support for himself and his professional ideas. Of course, he should be able to express himself

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 15clearly and simply and must always try to minimize the use of technical terminology in communicating with his management executives. For, it is well-known that if management does not understand, it will almost automatically reject. Further, while intellectually he must be in tune with industrys thinking the wider national perspective should not be absents from his advice to top management.

Questions on Managerial Economics1. Define managerial economics with definition.2. How does managerial economics differ from economics? 3. Write a short note on managerial economist. 4. Explain the scope of managerial economics. 5. Explain role and responsibilities of managerial economist.

DemandFactors which determine price Elasticity of demandprice elasticity of demand Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X

If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price elasticity = 2.0 If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity = 0.25 If the PED is equal to one, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change in price. Demand changes proportionately to a price change. If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical. If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This demand curve is associated with firms operating in perfectly competitive markets

A relatively elastic demand curve


A relatively inelastic demand curve

Factors that determine the value of price elasticity of demand: 1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong. 2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for opera tickets is more elastic than the

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 17demand for urban rail travel. The demand for vacation air travel is more elastic than the demand for business air travel. 3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be. 4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand. Preferences are such that habitual consumers of certain products become de-sensitised to price changes. 5. Time period under consideration - Demand tends to be more elastic in the long run rather than in the short run. For example, after the two world oil price shocks of the 1970s - the "response" to higher oil prices was modest in the immediate period after price increases, but as time passed, people found ways to consume less petroleum and other oil products. This included measures to get better mileage from their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil became more elastic in the long-run. Factors Determining Price Elasticity of Demand: The price elasticity of demand is not the same for all commodities. It may be or low depending upon number of factor. These factors which influence price elasticity of demand, in brief, are as under: (i) Nature of Commodities. In developing countries of the world, the per capital income of the people is generally low. They spend a greater amount of their income on the purchase of necessaries of life such as wheat, milk, course cloth etc. They have to purchase these commodities whatever be their price. The demand for goods of necessities is, therefore, less elastic or inelastic. The demand for luxury goods, on the other hand is greatly elastic. For example, if the price of burger falls, its demand in the cities will go up. (ii) Availability of substitutes. If a good has greater number of close substitutes available in the market, the demand for the good will be greatly elastic. For examples, if the price of Coca Cola rises in the market, people will switch over to the consumption of Pepsi Cola. which is its close substitute. So the demand for Coca Cola is elastic. (iii) Proportion of the income spent on the good. If the proportion of income spent on the purchase of a good is very small, the demand for such a good will be inelastic. For example, if the price of a box of matches or salt rises by 50%, it will not affect the consumers demand for these goods. The demand for salt, maker box therefore will be inelastic. On the other hand, if the price of a car rises from $6 lakh to $9 lakh and it takes a greater portion of the income of the consumers, its demand would fall. The demand for car is, therefore, elastic. (iv) Time. The period of time plays an important role in shaping the demand curve. In the short run, when the consumption of a good cannot be postponed, its demand will be less elastic. In the long run if the rise price persists, people will find out methods to reduce the consumption of goods. So the demand for a good in the, long run is elastic, other things remaining constant. For example if the price of electricity goes up, it is very difficult to cut back its consumption in the short run. However, if the rise in price persists, people will plan substitution gas heater, fluorescent bulbs etc. so that they use less^electricity. So the electricity of demand will be greater (Ep = > 1) in the long run than in the short run. (5) Number of uses of a good. If a good can be put to a number of uses, its demand is greater elastic (Ep > 1). For example, if the price of coal falls, its quantity demanded will rise considerably because demand will be coming from households, industries railways etc. (6) Addition. If a product is habit forming say for example, cigarette, the rise in its price would not induce much change in demand. The demand for habit forming- good is, therefore, less elastic. (7) Joint demand. If two goods are Jointly demand, then the elasticity of demand depends upon the elasticity of demand of the other Jointly demanded good. For example, with the rise in price of cars, its demand is slightly affected, then the demand for petrol will also be less elastic.


Factors that influence a demand for a product1)Changes in the Price of a good or service (2)Changes in consumers Income spent on goods and services (3)Changes in the Tastes/Preferences of consumers for goods/services (4)Changes in the Prices of related goods and services: Substitutes and Complements (5)Changes in government fiscal policy (spending and taxation) and monetary policy (interest rate etc) (6)Natural disasters (storms, hurricanes, earthquakes, tornadoes, floods etc) (7)Scientific discoveries (medical, chemical etc) (8)Advertising or Commercial ads (9)Changes in the growth rate of a Population (10)The # of consumers in a market (11)Seasonality (Christmas, Easter, Valentines Day etc) (12)Sociological factors (age, sex, education, marriage etc)

Factors That Can Influence A Products DemandBusinesses always have a volatile environment because its affected by the marketplaces supply and demand. The demands in the market will also affect the supply because of the factors that contribute to it. Looking into each of these factors are essential in order to cope with the changes. One of the most vital determinants of demand is the customers income. If the customers income decreases, so is their ability to purchase goods. The demand for a product can also be influenced by this factor: prices of related goods. For example, customers who are used to buying banana would buy more apples instead if the price of an apple decreases for a particular season. Because the customers then buy more apples due to its low price, the banana industry will suffer. The shifting taste of the market is also a determinant of demand. Trends in the market can affect the demand in some of the products. Its a fact that individuals tastes can reflect on the markets overall demand. For instance, if some customers prefer chocolate over coffee then the demand for chocolate will be higher compared to coffee. The demand for a particular good or service right now can be affected by expectations in the future. For instance, if you are expecting to earn more money in the future, then its likely youll be inclined to spend money today. But if you are expecting several financial difficulties in the near future, then you wouldnt be spending a lot right now because youd want to save your money. The number of buyers in the market will drive up the production of these goods, thus also having an overall effect on the demand. The number of buyers can also determine the prices of these goods. It is essential to any business owner to thoroughly and individually know each determinant of demand. This is important because the industry you are in is dependent on the demands of the market. In order of a business to survive, then you need to follow the trends and know where the demands of the market is going. These are but a few examples of determinants of demand and other factors can still affect demand.

Movement Vs Shifts of Demand CurveChanges in demand for a commodity can be shown through the demand curve in two ways: (1) Movement along the demand curve and (2) Shifts of the demand curve. (1) Movement along the Demand Curve: Demand is a multivariable function. If income and other determinants of demand such as tastes, of the consumers, changes in prices of related goods, income distribution etc remain constant and there is a change only in price of the commodity, then we move along the same demand curve, In this case, the demand curve remains unchanged. When, as a result of change in price, the quantity demanded increases or decreases, it is technically called extension and contraction in demand.

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 19The demand curve, which represents various price quantity has a negative slope. Whenever there is a change in the quantity demanded of a good due to change, in its price, there is a movement from one point price quantity combination to another on the same demand curve. Such a movement from one point price quantity combination to another along the same demand curve is shown in figure (4.3).

Here the price of a commodity falls from $8 to $2. As a result, therefore, the quantity demanded increases from 100 units to 400 units per unit of time. There is extension in demand by 300 units. This movement is from .one point price quantity combination (a) to another point (b) along a given demand curve. On the other hand, if the price of a good rises from $2 to 8, there is contraction in demand by 300 units. We, thus, see that as a result of change in the price of a good, the consumer moves along the given demand curve. The demand curve remains the same and does not change its position. The movement along the demand curve is designated as change in quantity demanded. (2) A Change or Shift-in Demand: Demand, as we know, is determined by many factors. When there is a change in demand due to one or more than one factors other than price, results in the shift of demand curve. For example, if the level of income in community rises, other factors remaining the same, the demand for the goods increases. Consumers demand more goods at each price per period of me (rise or Increase in demand). The demand curve shifts upward from he original demand curve indicating that consumers at each price purchase more units of commodity per unit of time. If there is a fall in the disposable income of the consumers or rise in the prices of' close substitute of a good or decline in consumer taste or non-availability of good on credit, etc, etc., there is a reduction in demand (fall or decrease in demand). The fall or decrease in demand shifts the. demand curve from the original demand curve to the left, The lower demand curve shows that consumers are able and willing to buy less of the good at each price than before. . dx dx dx dx P ($) Q Rise in Q Fall in Q

12 6 4

100 250 500

300 500. 600

50 200 300


In this figure, (4.4) the original demand curve is DD .At a price of $12 per unit, consumers purchase 100 units. When price falls to$4 per unit, the quantity demanded increases to 500 units per unit of time. Let us assume now that level of income increases in a community. Now consumers demand 300 units of the commodity at price of $12 per 2 unit and 600 at price of $4 per unit. As a result, there is an upward shift of the demand curve DD . In case the community income falls, there is then decrease in demand at price of $12 per unit. The quantity demanded of a good falls to 50 units. It is 300 units at price of $4 unit per period of time. There is a downward shift of the demand to the left of the original demand curve. Summing Up: (1) Extension in demand is due to reduction in price. Increase in demand occurs due to changes in factors other than price. (2) Contraction in demand is the result of a rise in the price commodity. A decrease in demand follows a change in factors-other than price (3) Changes in demand both increase and decrease are represent shifts in the demand curve. (4) Changes in the quantity demanded are represented by movealong the same demand curve.

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DEMAND FORECASTING

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 21Regression Analysis: Past data is used to establish a functional relationship between two variables. For Example, demand for consumer goods has a relationship with income of Individuals and family; demand for tractors is linked to the agriculture income and demand for cement, bricks etc. are dependent upon value of construction contracts at any time. Forecasters collect data and build relationship through co-relation and regression analysis of variables. Econometric Models: Econometric models are more complex and comprehensive as this model uses mathematical and statistical tools to forecast demand. This model takes various factors which affect the demand. For example, demand for passenger transport is not only dependent upon the population of the city, geographical area, industrial units, their location etc. It is not easy to locate one single economic indicator for determining the demand forecast of a product. Invariably, a multi-factor situation applies Econometric Models, although complex, are being increasingly used for market analysis and demand forecasts. Simple Average Method: Among the quantitative techniques for demand analysis, simple Average Method is the first one that comes to one's mind. Herein, we take simple average of all past periods - simple monthly average of all consumption figures collected every month for the last twelve months or simple quarterly average of consumption figures collected for several quarters in the immediate past. Thus,

Sum of Demands of all periods =

Theory of Consumer Behavior: There are two main approaches to the of consumer behavior of demand. The first approach is the Marginal Utility or Cardinalist Approach. The second is the Ordinalist Approach. We discuss these two approaches separately. Cardinal Utility Analysis: Human wants are unlimited and they are of different intensity. The means at the disposal of a man are not only scarce but they have alternative uses. As a result of scarcity of recourses, the consumer cannot satisfy all his wants. He has to choose as to which want is to be satisfied first and which afterward if the recourses permit. The consumer is confronted in making a choice. For example, a man is thirsty. He goes to the market and satisfy his thirst by purchasing coca-cola instead of tea.. We are here to examine the economic forces which make him purchase a particular commodity. The answer is simple. The consumer buys a commodity because

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 22it gives him satisfaction. In technical term, a consumer purchases a commodity because it has utility for him. We now examine the tools which are used in the analyzes of consumer behavior.

Concept of Utility:Jevon (1835-1882) was the first economist who introduces the concept of utility in economics. According to him utility is the basis on which the demand of a individual for a commodity depends upon Utility is defined as the power of a commodity or service to satisfy human want. Utility is thus the satisfaction which is derived by the consumer by consuming the goods. For example, cloth has a utility for us because we can wear it. Pen has a utility who can write with it. The utility is subjective in nature. It differs from person to person. The utility of a bottle of wine is zero for a person who is non drinker while it has a very high utility for a drinker. Here it may be noted that the term utility may not be confused with pleasure or unfulness which a commodity gives to an individual. Utility is a subjective satisfaction which consumer gets from consuming any good or service. For example, poison is injurious to health but it gives subjective satisfaction to a person who wishes to die. We can say that utility is value neutral. Assumptions of Cardinal Utility Analysis: The main assumption or premises on which the cardinal utility analysis rests are as under. Rationality. The consumer is rational. He seeks to maximize satisfaction from the limited income which is at his disposal. Utility is cardinally measurable. The utility can be measured in cardinal numbers such as 1, 3, 10, 15, etc. The utility is expressed in imaginary cardinal numbers tells us a great deal about the preference of the consumer for a good. Marginal utility of money remains constant. Another important premise of cardinal utility of money spent on the purchase of a good or service should remain constant. Diminishing marginal utility. It is also assumed that the marginal utility obtained from the consumption of a good diminishes continuously as its consumption is increased. Independent utilities. According to the Cardinalist school, the utility which is derived from the consumption of a good is a function of the quantity of that good alone. If does not depend at all upon the quantity consumed of other goods. The goods, we can say, possess independent utilities and are additive. Introspection method. The Cardinalist school assumes that the behavior of marginal utility in the mind of another person can be judged with the help of self observation. For example, I know that as I purchase more and more of a good, the less utility I derived from the additional units of it. By applying the same principle, I can read other people mind and say with confidence that marginal utility of a good diminishes as they have more units of it. Pareto, an Italian Economist, severely criticized the concept of cardinal utility. He stated that utility is neither quantifiable nor addible. It can, however be compared. He suggested that the concept of utility should be replaced by the scale of preference. Hicks and Allen, following the footsteps of Pareto, introduced the technique of indifference curves. The cardinal utility approach is thus replaced by ordinal utility function.


i. ii. iii. iv.

The total utility curves starts at the origin as zero consumption of apples yield zero utility. The TU curve reaches at its maximum or a peak of M when MU is zero. The MU curve falls through the graph. A special point occurs when the consumer consumes fifth apple. He gains no marginal utility from it. After this point, marginal utility becomes negative. The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent quantities on the curve. For example, the marginal utility of the third apple is the slope of line joining points a and b. The slope of such given by the formula;

MU = TU / Q Here MU = 2.

Law of Diminishing Marginal Utility:Definition and Statement of the Law: The law of diminishing marginal utility describes a familiar and fundamental tendency of human behavior. The law of diminishing marginal utility states that: As a consumer consumes more and more units of a specific commodity, the utility from the successive units goes on diminishing. Mr. H. Gossen, a German economist, was first to explain this law in 1854. Alfred Marshal later on restated this law in the following words: The additional benefit which a person derives from an increase of his stock of a thing diminishes with every increase in the stock that already has. Law is Based Upon Three Facts: The law of diminishing marginal utility is based upon three facts. First, total wants of a man are unlimited but each single want can be satisfied. As a man gets more and more units of a commodity, the desire of his for that good goes on falling. A point is reached when the consumer no longer wants any more units of that good. Secondly, different goods are not perfect substitutes for each other in the satisfaction of various particular wants. As such the marginal utility will decline as the consumer gets additional units of a specific good. Thirdly, the marginal utility of money is constant given the consumers wealth. The basis of this law is a fundamental feature of wants. It states that when people go to the market for the purchase of commodities, they do not attach equal importance to all the commodities which they buy. In case of some of commodities, they are willing to pay more and in some less. There are two main reasons for this difference in demand. (1) the linking of the consumer for the commodity and (2) the quantity of the commodity which the consumer has with himself. The more one has of a thing, the less he wants the additional units of it. In other words, the marginal utility of a commodity diminishing as the consumer gets larger quantities of it. This, in brief, is the axiom of law of diminishing marginal utility. Explanation and Example of Law of Diminishing Marginal Utility: This law can be explained by taking a very simple example. Suppose, a man is very thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives him immense pleasure or we say the first

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 24glass of water has great utility for him. If he takes second glass of water after that, the utility will be less than that of the first one. It is because the edge of his thirst has been blunted to a great extent. If he drinks third glass of water, the utility of the third glass will be less than that of second and so on. The utility goes on diminishing with the consumption of every successive glass water till it drops down to zero. This is the point of satiety. It is the position of consumers equilibrium or maximum satisfaction. If the consumer is forced further to take a glass of water, it leads to disutility causing total utility to decline. The marginal utility will become negative. A rational consumer will stop taking water at the point at which marginal utility becomes negative even if the good is free. In short, the more we have of a thing, ceteris paribus, the less we want still more of that, or to be more precise. In given span of time, the more of a specific product a consumer obtains, the less anxious he is to get more units of that product or we can say that as more units of a good are consumed, additional units will provide less additional satisfaction than previous units. The following table and graph will make the law of diminishing marginal utility more clear.

Schedule of Law of Diminishing Marginal Utility:Units 1st glass 2nd glass 3rd glass 4th glass 5th glass 6th glass Total Utility 20 32 40 42 42 39 Marginal Utility 20 12 8 2 0 -3

From the above table, it is clear that in a given span of time, the first glass of water to a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes on down to 12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into disutility (-3). Here it may be noted that the utility of then successive units consumed diminishes not because they are not of inferior in quality than that of others. We assume that all the units of a commodity consumed are exactly alike. The utility of the successive units falls simply because they happen to be consumed afterwards.

Curve/Diagram of Law of Diminishing Marginal Utility:The law of diminishing marginal utility can also be represented by a diagram.


In the figure (2.2), along OX we measure units of a commodity consumed and along OY is shown the marginal utility derived from them. The marginal utility of the first glass of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called satiety point. The MU of the 6th glass of water is / negative (-3). The MU curve here lies below the OX axis. The utility curve MM falls left from left down to the right showing that the marginal utility of the success units of glasses of water is falling.

Assumptions of Law of Diminishing Marginal Utility:The law of diminishing marginal utility is true under certain assumptions. These assumptions are as under: (i) Rationality: In, it is assumed that the consumer is rational. He aims at maximization of utility subject to availability of his income. (ii) Constant marginal utility of money: It is assumed in the theory that the marginal utility of money based for purchasing goods remains constant. If the marginal utility of money changes with the increase or decrease in income, it then cannot yield correct measurement of the marginal utility of the good. (iii) Diminishing marginal utility: Another important assumption of utility analysis is that the utility gained from the successive units of a commodity diminishes in a given time period. (iv) Utility is additive: In the early versions of the theory of consumer behavior, it was assumed that the utilities of different commodities are independent. The total utility of each commodity is additive. U = U (X ) + U (X ) + U (X ). U (X ) (v) Consumption to be continuous: It is assumed in this law that the consumption of a commodity should be continuous. If there is interval between the consumption of the same units of the commodity, the law may not hold good. For instance, if you take one glass of water in the morning and the 2nd at noon, the marginal utility of the 2nd glass of water may increase. (vi) Suitable quantity: It is also assumed that the commodity consumed is taken in suitable and reasonable units. If the units are too small, then the marginal utility instead of falling may increase up to a few units. (vii) Character of the consumer does not change: The law holds true if there is no change in the character of the consumer. For example, if a consumer develops a taste for wine, the additional units of wine may increase the marginal utility to a drunkard. (viii) No change to fashion: Customs and tastes: If there is a sudden change in fashion or customs or taste of a consumer, it can than make the law inoperative. (ix) No change in the price of the commodity: there should be any change in the price of that commodity as more units are consumed.1 1 2 2 3 3 n n

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 26There are some exceptions or limitations to the law of diminishing utility.

Limitations/Exceptions of Law of Diminishing Marginal Utility:(i) Case of intoxicants: Consumption of liquor defies the low for a short period. The more a person drinks, the more likes it. However, this is truer only initially. A stage comes when a drunkard too starts taking less and less liquor and eventually stops it.

(ii) Rare collection: If there are only two diamonds in the world, the possession of 2nd diamond will push up the marginal utility. (iii) Application to money: The law equally holds good for money. It is true that more money the man has, the greedier he is to get additional units of it. However, the truth is that the marginal utility of money declines with richness but never falls to zero. Summing up, we can say that the law of diminishing utility, like other laws of Economics, is simply a statement of tendency. It holds good provided other factors remain constant.

Practical Importance of Law of Diminishing Marginal Utility:The law of diminishing utility has great practical importance in economics. The law of demand, the theory of consumers surplus, and the equilibrium in the distribution of expenditure are derived from the law of diminishing marginal utility. (i) Basis of the law of demand: The law of marginal diminishing utility and the law of demand are very closely related to each other. In fact they law of diminishing marginal utility, the more we have of a thing, and the less we want additional increment of it. In other words, we can say that as a person gets more and more of a particular commodity, the marginal utility of the successive units begins to diminish. So every consumer while buying a particular commodity compares the marginal utility of the commodity and the price of the commodity which he has to pay. If the marginal utility of the commodity is higher than that of price, he purchases that commodity. As he buys more and more, the marginal utility of the successive units begins to diminish. Then he pays fewer amounts for the successive units. He tries to equate at every step the marginal utility and the price of the commodity, he must lower its price so that the consumers are induced to buy large quantities and this is what is explained in the law of demand. From this, we conclude that the law of demand and the law of diminishing are very closely inter-related. (ii) Consumers surplus concept: The theory of consumers surplus is also based on the law of diminishing marginal utility. A consumer while purchasing the commodity compares the utility of the commodity with that of the price which he has to pay. In most of the cases, he is willing to pay more than what he actually pays. The excess of the price which he would be willing to pay rather than to go without the thing over that which he actually does pay is the economic measure of this surplus satisfaction. It is in fact difference between the total utility and the actually money spent.

(iii) Importance to the consumer: A consumer in order to get the maximum satisfaction from his relatively scare resources distributes his income on commodities and services in such a way that the marginal utility from all the uses are the same. Here again the concept of marginal utility helps the consumer in arranging his scale of preference for the commodities and services. (iv) Importance to finance minister: Some times it is pointed out that the law of diminishing marginal utility does not apply on money. As a person collects money, the desires to accumulate more money increases. This view is superficial. It is true that wealth is acquired for the procurement of goods and services and man is always anxious in getting more and more of money. But what about the utility of money to him? Is it not a fact

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 27that as a person gets more and more wealth, its utility progressively decreases, though it does not reach to zero? For example, a person who earns $90,000 per month attaches less importance to $10. But a man who gets $1000 per month, the value of $10 to him is very high. A finance minister knowing this fact that the utility of money to a rich man is high and to poor man low bases the system of taxation in such a way that the rich persons are taxed at a progressive rate. The system of modern taxation is therefore, based on the law of diminishing marginal utility.

Law of Equi-Marginal Utility(Equilibrium of the Consumer Through the Law of Equi-Marginal Utility):Other Names of this Law:

Law of Substitution OR Law of Maximum Satisfaction OR Law of Indifference OR Proportion Rule OR Gossen's Second LawIn the cardinal utility analysis, the principle of equal marginal utility occupies an important place.

Definition and Statement of Law of Equi-Marginal Utility:The law of equi-marginal utility is simply an extension of law of diminishing marginal utility to two or more than two commodities. The law of equilibrium utility is known, by various names. It is named as the Law of Substitution, the Law of Maximum Satisfaction, the Law of Indifference, the Proportionate Rule and the Gossens Second Law. In cardinal utility analysis, this law is stated by Lipsey in the following words: The household maximizing the utility will so allocate the expenditure between commodities that the utility of the last penny spent on each item is equal. As we know, every consumer has unlimited wants. However, the income this disposal at any time is limited. The consumer is, therefore, faced with a choice among many commodities that he can and would like to pay. He, therefore, consciously or unconsciously compress the satisfaction which he obtains from the purchase of the commodity and the price which he pays for it. If he thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price, he buys that commodity. As he buys more and more of that commodity, the utility of the successive units begins to diminish. He stops further purchase of the commodity at a point where the marginal utility of the commodity and its price are just equal. If he pushes the purchase further from his point of equilibrium, then the marginal utility of the commodity will be less than that of price and the household will be loser. A consumer will be in equilibrium with a single commodity symbolically:

MUx = PxA prudent consumer in order to get the maximum satisfaction from his limited means compares not only the utility of a particular commodity and the price but also the utility of the other commodities which he can buy with his scarce resources. If he finds that a particular expenditure in one use is yielding less utility than that of other, he will tie to transfer a unit of expenditure from the commodity yielding less marginal utility. The consumer will reach his equilibrium position when it will not be possible for him to increase the total utility by uses. The position of equilibrium will be reached when the marginal utility of each good is in proportion to its price and the ratio of the prices of all goods is equal to the ratio of their marginal utilities. The consumer will maximize total utility from his income when the utility from the last rupee spent on each good is the same. Algebraically, this is:

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 28 MUa / Pa = MUb / Pb = MUc = Pc = MUn = Pn Here: (a), (b), (c). (n) are various goods consumed.

Assumptions of Law of Equi-Marginal Utility:The main assumptions of the law of equi-marginal utility are as under. (i) Independent utilities. The marginal utilities of different commodities are independent of each other and diminish with more and more purchases. (ii) Constant marginal utility of money. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchase of goods. (iii) Utility is cardinally measurable. (iv) Every consumer is rational in the purchase of goods.

Example and Explanation of Law of Equi-Marginal Utility:The doctrine of equi-marginal utility can be explained by taking an example. Suppose a person has $5 with him whom he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

Units of Money 1 2 3 4 5 $5

MU of Tea 10 8 6 4 2 Total Utility = 30

MU of Cigarettes 12 10 8 6 3 Total Utility = 30

A rational consumer would like to get maximum satisfaction from $5.00. He can spend money in three ways: (i) $5 may be spent on tea only. (ii) $5 may be utilized for the purchase of cigarettes only. (iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes. If the prudent consumer spends $5 on the purchase of tea, he gets 30 utility. If he spends $5 on the purchase of cigarettes, the total utility derived is 39 which are higher than tea. In order to make the best of the limited resources, he adjusts his expenditure. (i) By spending $4 on tea and $1 on cigarettes, he gets 40 utility (10+8+6+4+12 = 40). (ii) By spending $3 on tea and $2 on cigarettes, he derives 46 utility (10+8+6+12+10 = 46). (iii) By spending $2 on tea and $3 on cigarettes, he gets 48 utility (10+8+12+10+8 = 48).

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 29(iv) By spending $1 on tea and $4 on cigarettes, he gets 46 utility (10+12+10+8+6 = 46). The sensible consumer will spend $2 on tea and $3 on cigarettes and will get maximum satisfaction. When he spends $2 on tea and $3 on cigarette, the marginal utilities derived from both these commodities is equal to 8. When the marginal utilities of the two commodities are equalizes, the total utility is then maximum, i.e., 48 as is clear from the schedule given above.

Curve/Diagram of Law of Equi-Marginal Utility:The law of equi-marginal utility can be explained with the help of diagrams.

In the figure 2.3 MU is the marginal utility curve for tea and KL of cigarettes. When a consumer spends OP amount ($2) on tea and OC ($3) on cigarettes, the marginal utility derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP = NC). The consumer gets the maximum utility when he spends $2 on tea and $3 on cigarettes and by no other alternation in the expenditure. We now assume that the consumer spends $1 on tea (OC amount) and $4 (OQ ) on cigarettes. If CQ more / / amounts are spent cigarettes, the added utility is equal to the area CQ N N. On the other hand, the / expenditure on tea falls from OP amount ($2) to OC amount ($1). There is a toss of utility equal to the area / C PEE. The loss is utility (tea) is greater than that The loss in utility (tea) is maximum satisfaction except the combination of expenditure of $2 on tea and $3 on cigarettes. This law is known as the Law of maximum Satisfaction because a consumer tries to get the maximum satisfaction from his limited resources by so planning his expenditure that the marginal utility of a rupee spent in one use is the same as the marginal utility of a rupee spent on another use. It is known as the Law of Substitution because consumer continuous substituting one good for another till he gets the maximum satisfaction. It is called the Law of Indifference because the maximum satisfaction has been achieved by equating the marginal utility in all the uses. The consumer than becomes indifferent to readjust his expenditure unless some change fakes place in his income or the prices of the commodities, etc./ / /

Limitations/Exceptions of Law of Equi-Marginal Utility:(i) Effect on fashions and customs: The law of equi-marginal utility may become inoperative if people forced by fashions and customs spend money on the purchase of those commodities which they clearly knows yield less utility but they cannot transfer the unit of money from the less advantageous uses to the more advantageous uses because they are forced by the customs of the country. (ii) Ignorance or carelessness: Sometimes people due to their ignorance of price or carelessness to weigh the utility of the purchased commodity do not obtain the maximum advantage by equating the marginal utility in all the uses. (iii) Indivisible units: If the unit of expenditure is not divisible, then again the law may become inoperative.

E c o n o m i c s F o r M a n a g e r i a l D e c i s i o n M a k i n g - 2 | 30(iv) Freedom of choice: If there is no perfect freedom between various alternatives, the operation of law may be impeded.

Importance of Law of Equi-Marginal Utility:The law of equi-marginal utility is of great practical importance. The application of the principle of substitution extends over almost every field of economic enquiry. Every consumer consciously trying to get the maximum satisfaction from his limited resources acts upon this principle of substitution. Same is the case with the producer. In the field of exchange and in theory of distribution too, this law plays a vital ro

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