Business economics is a field of applied economics that studies the financial,

organizational, market-related, and environmental issues faced by corporations.

Economic theory and quantitative methods form the basis of assessments on factors
affecting corporations such as business organization, management, expansion, and
strategy. Studies might include how and why corporations expand, the impact
of entrepreneurs, the interactions among corporations, and the role of governments in
regulation.

The Basics of Business Economics

Economics, broadly, refers to the study of the components and functions of a particular
marketplace or economy, such as supply and demand, and the effect of the concept of
scarcity. Within an economy, production factors, distribution methods, and consumption
are important subjects of study. Business economics focuses on the elements and
factors within business operations and how they relate to the economy as a whole.

The field of business economics addresses economic principles, strategies, standard

business practices, the acquisition of necessary capital, profit generation, the efficiency
of production, and overall management strategy. Business economics also includes the
study of external economic factors and their influence on business decisions such as a
change in industry regulation or a sudden price shift in raw materials.

Real World Example of Business Economics

There are various organizations associated with the field of business economics. In the
United States, the National Association for Business Economics (NABE) is the
professional association for business economists. The organization’s mission is “to
provide leadership in the use and understanding of economics.” In the United Kingdom,
the equivalent organization is the Society of Business Economists.

• Economic theory and quantitative methods form the basis of microeconomic

assessments of factors affecting corporations.
• Business economics encompasses subjects such as the concept of scarcity, product
factors, distribution, and consumption.
• Managerial economics is one important offshoot of business economics.
• The National Association for Business Economics (NABE) is the professional
association for business economists in the United States.

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Nature of Business Economics
(i) Business Economics is a Science

What is Science? It is simply a systematic body of knowledge which can establish a

relationship between cause and effect. Further, Mathematics, Statistics, and
Econometrics are decision sciences.

Business Economics integrates these decision sciences with Economic Theory to arrive
at strategies to help businesses achieve their goals. Hence, it follows scientific methods
and also tests the validity of the results. This is one aspect of the nature of business
economics.

(ii) It is based on Micro Economics

We understand the basic difference between micro and macroeconomics. A business

manager is certainly more concerned about achieving the objectives of his own
organization. After all, this helps him in ensuring profits and long-term survival of the
firm.

Business Economics is more concerned with the decision-making situations of

individual establishments. Therefore, it depends on the techniques of Microeconomics.

(iii) It Incorporates Elements of Macro Analysis

Even though all businesses focus on their profitability and survival, a firm cannot
operate in a vacuum. The external environment of the economy like income and
employment levels in the economy, tax policies, etc., affects the firm. All these external
factors are components of macro economy.

Therefore, a business manager has to take all such factors into consideration which
may influence his business environment.

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 (iv) It is an Art

Business Economics is an art as it requires the practical application of rules and

principle to achieve set objectives.

(v) Use of Theory of Markets and Private Enterprises

Business Economics primarily uses the theory of markets and private enterprises. It
uses the theory of the firm and resource allocation in a private enterprise economy.

(vi) Pragmatic in Approach

Microeconomics is purely theoretical and analyzes economic occurrences under

unrealistic assumptions. On the other hand, Business Economics is pragmatic in its
approach. It tries to solve the problems which the firms face in the real world.

(vii) Interdisciplinary

Business Economics incorporates tools from many other disciplines like mathematics,
statistics, accounting, marketing, etc. Therefore, is in interdisciplinary in nature.

(viii) Normative

Broadly speaking, Economic Theory has evolved along two lines – Positive and
Normative.

A positive or pure science analyzes the cause and effect relationship between variables
in a scientific manner. However, it does not involve any value judgment. In simpler
words, it describes the economic behavior of individuals or society without focusing on
the desirability of such behavior.

On the other hand, normative science involves value judgments. It suggests a course of
action under the given circumstances.

Usually, Business Economics is normative in nature. It offers suggestions for the

application of economic principles while forming policies, making decisions, and
planning for the future. However, firms must understand their environment thoroughly to
establish decision rules. This requires the study of positive economic theory.

Therefore, we can say that Business Economics combines the essentials of both the
theories while keeping more emphasis on the normative economic theory.

The Scope of Business Economics

1. Microeconomics Applied to Operational Issues

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 As the name suggests, internal or operational issues are issues that arise within a firm
and are within the control of the management. It is within the scope of business
economics to analyze this.

Further, a few examples of such issues are choice of business, size of business,
product designs, pricing, promotion for sales, technology choice, etc. Most firms can
deal with these using the following microeconomics theories:

(i) Analyzing Demand and Forecasting

Analyzing demand is all about understanding buyer behavior. It studies the preferences
of consumers along with the effects of changes in the determinants of demand. Also,
these determinants include the price of the good, consumer’s income, tastes/
preferences, etc.

Forecasting demand is a technique used to predict the future demand for a good and/or
service. Further, this prediction is based on the past behavior of factors which affect the
demand. This is important for firms as accurate predictions help them produce the
required quantities of goods at the right time.

Further, it gives them enough time to arrange various factors of production in advance
like raw materials, labor, equipment, etc. Business Economics offers scientific tools
which assist in forecasting demand.

(ii) Production and Cost Analysis

A business economist has the following responsibilities with regards to the production:

• Decide on the optimum size of output based on the objectives of the firm.
• Also, ensure that the firm does not incur any undue costs.

By production analysis, the firm can choose the appropriate technology offering a
technically efficient way of producing the output. Cost analysis, on the other hand,
enables the firm to identify the behavior of costs when factors like output, time period,
and the size of plant change. Further, by using both these analyses, a firm can
maximize profits by producing optimum output at the least possible cost.

(iii) Inventory Management

Firms can use certain rules to reduce costs associated with maintaining inventory in the
form of raw materials, work in progress, and finished goods. Further, it is important to
understand that the inventory policies affect the profitability of a firm. Hence, economists
use methods like the ABC analysis and mathematical models to help the firm in
maintaining an optimum stock of inventories.

(iv) Market Structure and Pricing Policies

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 Any firm needs to know about the nature and extent of competition in the market. A
thorough analysis of the market structure provides this information. Further, with the
help of this, firms command a certain ability to determine prices in the market. Also, this
information helps firms create strategies for market management under the given
competitive conditions.

Price theory, on the other hand, helps the firm in understanding how prices are
determined under different kinds of market conditions. Also, it assists the firm in creating
pricing policies.

(v) Resource Allocation

Business Economics uses advanced tools like linear programming to create the best
course of action for an optimal utilization of available resources.

(vi) Theory of Capital and Investment Decisions

Among other decisions, a firm must carefully evaluate its investment decisions an
allocate its capital sensibly. Various theories pertaining to capital and investments offer
scientific criteria for choosing investment projects. Further, these theories also help the
firm in assessing the efficiency of capital. Business Economics assists the decision-
making process when the firm needs to decide between competing uses of funds.

(vii) Profit Analysis

Profits depend on many factors like changing prices, market conditions, etc. The profit
theories help firms in measuring and managing profits under such uncertain conditions.
Further, they also help in planning future profits.

(viii) Risk and Uncertainty Analysis

Most businesses operate under a certain amount of risk and uncertainty. Also,
analyzing these risks and uncertainties can help firms in making efficient decisions and
formulating plans.

2. Macroeconomics applied to Environmental Issues

External or environmental factors have a measurable impact on the performance of a

business. The major macroeconomic factors are:

• Type of economic system

• Stage of the business cycle
• General trends in national income, employment, prices, saving, and investment.
• Government’s economic policies
• Performance of the financial sector and capital market
• Socio-economic organizations
• Social and political environment.

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 The management of a firm has no control over these factors. Therefore, it is important
that the firm fine-tunes its policies to minimize the adverse effects of these factors.

Difference between Business Economics and Economics

We are aware that Business Economics has evolved from Traditional Economics. Even
though there are many similarities between them, but there are certain differences
between the two.

1. Economics focuses primarily with the theoretical aspect whereas Business Economics
devotes with the practical aspect. The former is associated with concepts, theories,
models and building theoretical framework. The latter is associated with the applications
of the selected theories and concepts to solve business problems and help the business
decision making process.
2. Business Economics is fundamentally micro-economic in nature. It studies the activities
of an individual firm or unit. There is an extensive application of the concepts and
theories of microeconomics in it. The Economics has both micro and macro aspects
within its purview.
3. Business Economics is essentially normative in nature. But, the Economics is
concerned with both positive and normative economics. Positive Economics explains
the economic phenomena as they are, while normative economics discusses as to what
they ought to be. Business Economics explains what objectives and avenues a
business should pursue and how they are to be. Therefore, it is normative in nature.
4. Economics studies the complex economic phenomena and rational human behaviour by
developing certain meaningful and consistent assumptions, hypothesis and developing
models. Business Economics endeavors to solve real life complex business problems. It
selectively applies economic models with required modifications to solve the business
problems.
5. Economics concentrates only the economic aspect of the problems but Business
Economics deals with some non-economic aspects of the problems along with the
economic aspects.
6. Business Economics focuses on the theory of profit only. Whereas, the Economics has
within its ambit not only profit maximization but also other aspects like Utility
maximization, distribution theories of wage, rent interest and welfare economics as well.
7. The scope of Business Economics is restricted as compared to the scope of the
Economics.

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Economics is a social science that attempts to explain how the actions and decisions of
firms, consumers and workers and governments affect the operation of the economy. It
plays a huge role in our daily lives; it has links to international affairs and politics and is
a subject that is often debated and discussed. It requires a fair deal of analysis and
includes topics such as supply and demand, growth, inflation, globalisation and
exchange rates.

Business Economics is more concerned with the actions and decisions taken by firms
and focuses on topics such as marketing, staff in the organisation, accounting and
finance, management, strategy and production methods. Business studies students
will also have to cover some Economics, as it affects how businesses operate in their
external environments.

Although Business Economics is not free from theory, it is less theoretical than
Economics. Business Studies requires less understanding than Economics, but it by
no means an easy subject; instead it involves more learning and therefore has more
work to cover, and a great deal of new terminology to grapple with. Therefore you might
say that Economics course has more depth, with the Business course having more
breadth.

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Topic 3 Contribution and Application of Business Economics to Economics

Managerial economics is the discipline, which deals with the application of economic
theory to business management. Managerial Economics thus lies on the margin
between economics and business management and serves as the bridge between the
two disciplines.

The 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:

(i) Reconciling traditional theoretical concepts of economics in relation to the

actual business behavior and conditions

In economic theory, the technique of analysis is that of model building. This involves
making some assumptions and, drawing conclusions on the basis of the assumptions
about the behavior of the firms. The assumptions, however, make the theory of the firm
unrealistic since it fails to provide a satisfactory explanation of what the firms actually
do. Hence, there is need to reconcile the theoretical principles based on simplified
assumptions with actual business practice and develop appropriate extensions and
reformulation of economic theory. For example, it is usually assumed that firms aim at
maximizing profits. Based on this, the theory of the firm suggests how much the firm
will produce and at what price it would sell. In practice, however, firms do not always
aim at maximum profits (as they may think of diversifying or introducing new product
etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of
the firm’s actual behavior. Moreover, in actual business language, certain terms like
profits and costs have accounting concepts as distinguished from economic concepts.
In managerial economics, an attempt is made to merge the accounting concepts with
the economics, an attempt is made to merge the accounting concepts with the
economic concepts. This helps in a more effective use of financial data related to profits
and costs to suit the needs of decision-making and forward planning.

(ii) Estimating economic relationships

This involves the measurement of various types of elasticities of demand such as price
elasticity, income elasticity, cross-elasticity, promotional elasticity and cost-output
relationships. The estimates of these economic relationships are to be used for the
purpose of forecasting.

(iii) Predicting relevant economic quantities

Economic quantities such as profit, demand, production, costs, pricing and capital are
predicated in numerical terms together with their probabilities. As the business manager
has to work in an environment of uncertainty, the future needs to be foreseen so that in
the light of the predicted estimates, decision-making and forward planning may be
possible.

(iv) Using economic quantities in decision-making and forward planning

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This involves formulating business policies for establishing future business plans. This
nature of economic forecasting indicates the degree of probability of various possible
outcomes, i.e., losses or gains that will occur as a result of following each one of the
available strategies. Thus, a quantified picture gets set up, that indicates the number of
courses open, their possible outcomes and the quantified probability of each outcome.
Keeping this picture in view, the business manager is able to decide about which
strategy should be chosen.

(v) Understanding significant external forces

Applying economic theory to business management also involves understanding the

important external forces that constitute the business environment and with which a
business must adjust. Business cycles, fluctuations in national income and government
policies pertaining to taxation, foreign trade, labor relations, anti-monopoly measures,
industrial licensing and price controls are typical examples. 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.

Topic 4 Micro vs. Macro Economics

Micro Economics
Microeconomics is the social science that studies the implications of human action,
specifically about how those decisions affect the utilization and distribution of scarce
resources. Microeconomics shows how and why different goods have different values,
how individuals make more efficient or more productive decisions, and how individuals
best coordinate and cooperate with one another. Generally speaking, microeconomics
is considered a more complete, advanced, and settled science than macroeconomics.

Microeconomics is the study of economic tendencies, or what is likely to happen when

individuals make certain choices or when the factors of production change. Individual
actors are often grouped into microeconomic subgroups, such as buyers, sellers, and
business owners. These groups create the supply and demand for resources, using
money and interest rates as a pricing mechanism for coordination.

The Uses of Microeconomics

As a purely normative science, microeconomics does not try to explain what should
happen in a market. Instead, microeconomics only explains what to expect if certain
conditions change. If a manufacturer raises the prices of cars, microeconomics says
consumers will tend to buy fewer than before. If a major copper mine collapses in South
America, the price of copper will tend to increase, because supply is restricted.
Microeconomics could help an investor see why Apple Inc. stock prices might fall if
consumers buy fewer iPhones. Microeconomics could also explain why a higher
minimum wage might force The Wendy’s Company to hire fewer workers.
Microeconomics can address questions like these that might have very broad
implications for the economy; however, questions about aggregate economic numbers

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remain the purview of macroeconomics, such as what might happen to the gross
domestic product (GDP) of China in 2020.

Method of Microeconomics

Most modern microeconomic study is performed according to general equilibrium

theory, developed by Léon Walras in Elements of Pure Economics (1874) and partial
equilibrium theory, introduced by Alfred Marshall in Principles of Economics (1890). The
Marshallian and Walrasian methods fall under the larger umbrella of neoclassical
microeconomics. Neoclassical economics focuses on how consumers and producers
make rational choices to maximize their economic well being, subject to the constraints
of how much income and resources they have available. Neoclassical economists make
simplifying assumptions about markets – such as perfect knowledge, infinite numbers of
buyers and sellers, homogeneous goods, or static variable relationships – in order to
construct mathematical models of economic behavior.

These methods attempt to represent human behavior in functional mathematical

language, which allows economists to develop mathematically testable models of
individual markets. As logical positivists, neoclassicals believe in constructing
measurable hypotheses about economic events, then using empirical evidence to see
which hypotheses work best. Unlike physicists or biologists, economists cannot run
repeatable tests, so their empirical research depends on the collection and observation
of economic data from real world markets. The economic efficiency of markets is then
determined by how well real markets adhere to the rules of the model.

Basic Concepts of Microeconomics

The study of microeconomics involves several key concepts, including (but not limited
to):

(i) Production theory

This is the study of production — or the process of converting inputs into outputs.
Producers seek to choose the combination of inputs and method of combining them that
will minimize cost in order to maximize their profits.

(ii) Utility theory

Analogous to production theory, consumers will choose to purchase and consume a

combination of goods that will maximize their happiness or “utility”, subject to the
constraint of how much income they have available to spend.

(iii) Price theory

Production theory and utility theory interact to produce the theory of supply and
demand, which determine prices in a competitive market. In a perfectly competitive
market, it concludes that the price demanded by consumers is the same supplied by
producers. That results in economic equilibrium.

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 (iv) Industrial organization and market structure

Microeconomists study the many ways that markets can be structured, from perfect
competition to monopolies, and the ways that production and prices will develop in
these different types of markets.

KEY TAKEAWAYS

• Microeconomics studies the decisions of individuals and firms to allocate resources of

production, exchange, and consumption.
• Microeconomics deals with prices and production in single markets and the interaction
between different markets, but leaves the study of economy-wide aggregates to
macroeconomics.
• Microeconomists use mathematics as a language to formulate theories and
observational studies to test their theories against the real world performance of market.

Macro Economics
Macroeconomics is a branch of economics that studies how the aggregate economy
behaves. In macroeconomics, economy-wide phenomena are examined such as
inflation, price levels, rate of economic growth, national income, gross domestic product
(GDP), and changes in unemployment.

Understanding Macroeconomics

There are two sides to the study of economics: macroeconomics and microeconomics.
As the term implies, macroeconomics looks at the overall, big picture scenario of the
economy. Put simply, it focuses on the way the economy performs as a whole, and then
analyzes how different sectors of the economy relate to one another to understand how
the economy functions. This includes looking at variables like unemployment, GDP, and
inflation. Macroeconomists develop models explaining relationships between these
factors. Such macroeconomic models, and the forecasts they produce, are used by
government entities to aid in the construction and evaluation of economic policy, by
businesses to set strategy in domestic and global markets, and by investors to predict
and plan for movements in various asset markets.

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 Given the enormous scale of government budgets and the impact of economic policy on
consumers and businesses, macroeconomics clearly concerns itself with significant
issues. Properly applied, economic theories can offer illuminating insights on how
economies function and the long-term consequences of particular policies and
decisions. Macroeconomic theory can also help individual businesses and investors
make better decisions through a more thorough understanding of what motivates other
parties and how to best maximize utility and scarce resources.

It is also important to understand the limitations of economic theory. Theories are often
created in a vacuum and lack certain real-world details like taxation, regulation and
transaction costs. The real world is also decidedly complicated and their matters of
social preference and conscience that do not lend themselves to mathematical analysis.

Even with the limits of economic theory, it is important and worthwhile to follow the
major macroeconomic indicators like GDP, inflation and unemployment. The
performance of companies, and by extension their stocks, is significantly influenced by
the economic conditions in which the companies operate and the study of
macroeconomic statistics can help an investor make better decisions and spot turning
points.

• Macroeconomics is the branch of economics that deals with the structure, performance,
behavior, and decision-making of the whole, or aggregate, economy, instead of focusing
on individual markets.
• The two main areas of macroeconomic study are long term economic growth and
shorter term business cycles.
• Macroeconomics first came to be distinguished from microeconomics with the work of
John Maynard Keynes and his arguments that macroeconomic aggregates can behave
in ways quite different from analogous microeconomic phenomena.

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Topic 5 Opportunity Cost, Time Value of Money
Opportunity costs
Opportunity costs represent the benefits an individual, investor or business misses out
on when choosing one alternative over another. While financial reports do not show
opportunity cost, business owners can use it to make educated decisions when they
have multiple options before them.

The term “opportunity cost” comes up often in finance and economics when trying to
choose one investment, either financial or capital, over another. It serves as a measure
of an economic choice as compared to the next best one. For example, there is an
opportunity cost of choosing to finance a company with debt over issuing stock.

Opportunity cost cannot always be fully quantified at the time when a decision is made.
Instead, the person making the decision can only roughly estimate the outcomes of
various alternatives, which means imperfect knowledge can lead to an opportunity cost
that will only become obvious in retrospect. This is a particular concern when there is a
high variability of return. To return to the first example, the foregone investment at 7%
might have a high variability of return, and so might not generate the full 7% return over
the life of the investment.

The concept of opportunity cost does not always work, since it can be too difficult to
make a quantitative comparison of two alternatives. It works best when there is a
common unit of measure, such as money spent or time used.

Opportunity cost is not an accounting concept, and so does not appear in the financial
records of an entity. It is strictly a financial analysis concept.

How is Opportunity Cost Calculated?

In financial analysis, the opportunity cost is factored into the present when calculating
Net Present Value formula.

NPV Formula

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Where:

NPV: Net Present Value

FCF: Free cash flow

r: Discount rate

n: Number of periods

When presented with mutually exclusive options, the decision-making rule is to choose
the project with the highest NPV. However, if the alternative project gives a single and
immediate benefit, the opportunity costs can be added to the total costs incurred in C0.
As a result, the decision rule then changes from choosing the project with the highest
NPV into undertaking the project if NPV is greater than zero.

Financial analysts use financial modeling to evaluate the opportunity cost of alternative
investments

Application of Opportunity Cost

For example, assume a firm discovered oil in one of its lands. A land surveyor
determines that the land can be sold at a price of $40 billion. A consultant determines
that extracting the oil will generate an operating revenue of $80 billion in present value
terms if the firm is willing to invest $30 billion today. The accounting profit would be to
invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50
billion. However, the economic profit for choosing to extract will be $10 billion because
the opportunity cost of not selling the land will be $40 billion.

Time Value of Money (TVM)

The time value of money (TVM) is the concept that money available at the present time
is worth more than the identical sum in the future due to its potential earning capacity.
This core principle of finance holds that, provided money can earn interest, any amount
of money is worth more the sooner it is received. TVM is also sometimes referred to as
present discounted value.

The time value of money draws from the idea that rational investors prefer to receive
money today rather than the same amount of money in the future because of money’s
potential to grow in value over a given period of time. For example, money deposited
into a savings account earns a certain interest rate and is therefore said to be
compounding in value.

Further illustrating the rational investor’s preference, assume you have the option to
choose between receiving $10,000 now versus $10,000 in two years. It’s reasonable to
assume most people would choose the first option. Despite the equal value at time of
disbursement, receiving the $10,000 today has more value and utility to the beneficiary
than receiving it in the future due to the opportunity costs associated with the wait. Such

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 opportunity costs could include the potential gain on interest were that money received
today and held in a savings account for two years.

Basic TVM Formula

Depending on the exact situation in question, the TVM formula may change slightly. For
example, in the case of annuity or perpetuity payments, the generalized formula has
additional or less factors. But in general, the most fundamental TVM formula takes into
account the following variables:

• FV = Future value of money

• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years

Based on these variables, the formula for TVM is:

FV = PV x [ 1 + (i / n) ] (n x t)

Topic 6 Marginalism, Incrementalism

Marginalism
Marginalism generally includes the study of marginal theories and relationships within
economics. The key focus of marginalism is how much extra use is gained from
incremental increases in the quantity of goods created, sold, etc. and how these
measures relate to consumer choice and demand.

Marginalism covers such topics as marginal utility, marginal gain, marginal rates of
substitution, and opportunity costs, within the context of consumers making rational
choices in a market with known prices. These areas can all be thought of as popular
schools of thought surrounding financial and economic incentives.

The idea of marginalism and its use in establishing market prices, as well as supply and
demand patterns, was popularized by British economist Alfred Marshall in a publication
dating back to 1890.

Marginalism is sometimes criticized as one of the “fuzzier” areas of economics, as much

of what is proposed is hard to accurately measure, such as an individual consumers’
marginal utility. Also, marginalism relies on the assumption of (near) perfect markets,
which do not exist in the practical world. Still, the core ideas of marginalism are
generally accepted by most economic schools of thought and are still used by
businesses and consumers to make choices and substitute goods.

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Modern marginalism approaches now include the effects of psychology or those areas
that now encompass behavioral economics. Reconciling neoclassic economic principles
and marginalism with the evolving body of behavioral economics is one of the exciting
emerging areas of contemporary economics.

Incrementalism
Incrementalism is a method of working by adding to a project using many small
incremental changes instead of a few (extensively planned) large jumps. Logical
incrementalism implies that the steps in the process are sensible. Logical
incrementalism focuses on “the Power-Behavioral Approach to planning rather than to
the Formal Systems Planning Approach”. In public policy, incrementalism is the method
of change by which many small policy changes are enacted over time in order to create
a larger broad based policy change. This was the theoretical policy of rationality
developed by Lindblom to be seen as a middle way between the rational actor model
and bounded rationality, as both long term goal driven policy rationality and satisficing
were not seen as adequate.

Most people use incrementalism without ever needing a name for it because it is the
natural and intuitive way to tackle everyday problems, such as making coffee or getting

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dressed. These actions normally don’t require extensive planning and problems can be
dealt with one at a time as they arise.

Even in processes that involve more extensive planning, incrementalism is often an

important tactic for dealing reactively with small details. For example, one might plan a
route for a driving trip on a map, but one would not typically plan in advance where to
change lanes or how long to stop at each streetlight.

The political scientist Charles E. Lindblom developed Incrementalism in the mid 1950s.
“The Science of Muddling Through” (1959), was an essay Lindblom wrote to help
policymakers understand why they needed to consider a different approach when
making policy changes. The goal for the new perspective of Incrementalism was for
policy makers to avoid making changes before they really engaged and rationally
thought through the issue.

Advantages of incrementalism
The advantages of incrementalism over other formal systems is that no time is wasted
planning for outcomes which may not occur.

(i) Politically expedient

Since it does not involve any radical and complete changes, it is easily accepted and
therefore the process is expedient.

(ii) Simplicity

It is very simple to understand. Compared to some of the other budgeting methods used
in business, it is one of the easiest to put in practice one does not have to be an
accountant or have much experience in business to use this form of budgeting.

(iii) Gradual change

A very stable budget exists from one period to the next and allows for gradual change
within the company. Many managers are intimidated by large budget increases from
one period to the next. This type of budget will not cause that problem because it is
based on the previous period’s budget.

(iv) Flexibility

It is very flexible. Doing it from one month to the next allows one to see change very
quickly when a new policy or budget is implemented.

(v) Avoiding conflict

Companies with many different departments often run into conflict between departments
because of their different budgets. With this method of budgeting, it is easier to keep
everyone on the same page and avoid conflicts between departments.

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 Market forces and Equilibrium, Risk, Return and Profits
Economic Equilibrium
Economic equilibrium is a condition or state in which economic forces are balanced. In
effect, economic variables remain unchanged from their equilibrium values in the
absence of external influences. Economic equilibrium is also referred to as market
equilibrium.

Economic equilibrium is the combination of economic variables (usually price and

quantity) toward which normal economic processes, such as supply and demand, drive
the economy. The term economic equilibrium can also be applied to any number of
variables such as interest rates or aggregate consumption spending. The point of
equilibrium represents a theoretical state of rest where all economic transactions that
“should” occur, given the initial state of all relevant economic variables, have taken
place.

KEY TAKEAWAYS

• Economic equilibrium is a condition where market forces are balanced, a concept

borrowed from physical sciences, where observable physical forces can balance each
other.
• The incentives faced by buyers and sellers in a market, communicated through current
prices and quantities drive them to offer higher or lower prices and quantities that move
the economy toward equilibrium.
• Economic equilibrium is a theoretical construct only. The market never actually reach
equilibrium, though it is constantly moving toward equilibrium.

Economic Equilibrium in the Real World

Equilibrium is a fundamentally theoretical construct that may never actually occur in an

economy, because the conditions underlying supply and demand are often dynamic and
uncertain. The state of all relevant economic variables changes constantly. Actually
reaching economic equilibrium is something like a monkey hitting a dartboard by
throwing a dart of random and unpredictably changing size and shape at a dartboard,
with both the dartboard and the thrower careening around independently on a roller rink.
The economy chases after equilibrium with out every actually reaching it.

With enough practice, the monkey can get pretty close though. Entrepreneurs compete
throughout the economy, using their judgement to make educated guesses as to the
best combinations of goods, prices, and quantities to buy and sell. Because a market
economy rewards those who guess better, through the mechanism of profits,
entrepreneurs are in effect rewarded for moving the economy toward equilibrium. The
business and financial media, price circulars and advertising, consumer and market
researchers, and the advancement of information technology all make information about
the relevant economic conditions of supply and demand more available to
entrepreneurs over time. This combination of market incentives that select for better
guesses about economic conditions and the increasing availability of better economic

18
 information to educate those guesses accelerates the economy toward the “correct”
equilibrium values of prices and quantities for all the various goods and services that
are produced, bought, and sold.

RISK
Risk takes on many forms but is broadly categorized as the chance an outcome or
investment’s actual return will differ from the expected outcome or return. Risk includes
the possibility of losing some or all of the original investment. Different versions of risk
are usually measured by calculating the standard deviation of the historical returns or
average returns of a specific investment.

A high standard deviation indicates a high degree of risk. Many companies allocate
large amounts of money and time in developing risk management strategies to help
manage risks associated with their business and investment dealings. A key component
of the risk management process is risk assessment, which involves the determination of
the risks surrounding a business or investment.

A fundamental idea in finance is the relationship between risk and return. The greater
the amount of risk an investor is willing to take, the greater the potential return.
Investors need to be compensated for taking on additional risk. For example, a U.S.
Treasury bond is considered one of the safest, or risk-free, investments and when
compared to a corporate bond, provides a lower rate of return. A corporation is much
more likely to go bankrupt than the U.S. government. Because the risk of investing in a
corporate bond is higher, investors are offered a higher rate of return.

There are several ways to measure risk, such as downside deviations, Roy’s safety first
ratio, and portfolio standard deviation. Measuring risk allows investors and traders to
hedge some of that risk away using various strategies including employing derivatives
positions.

KEY TAKEAWAYS

• Risk takes on many forms but is broadly categorized as the chance an outcome or
investment’s actual return will differ from the expected outcome or return.
• Risk includes the possibility of losing some or all of the original investment.
• There are several ways to quantify risk including standard deviation, VaR, and the
safety-first ratio.
• Risk can be reduced using hedging strategies to insure against some losses.

Types of Financial Risk

Market risk and specific risk are two different forms of risk that affect assets. All
investment assets can be separated by two categories: systematic risk and
unsystematic risk. Market risk, or systematic risk, affects a large number of asset
classes, whereas specific risk, or unsystematic risk, only affects an industry or particular
company.

(i) Systematic risk

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It is the risk of losing investments due to factors, such as political risk and
macroeconomic risk, that affect the performance of the overall market. Market risk is
also known as volatility and can be measured using beta. Beta is a measure of an
investment’s systematic risk relative to the overall market.

(ii) Market risk

It cannot be mitigated through portfolio diversification. However, an investor can hedge

against systematic risk. A hedge is an offsetting investment used to reduce the risk in
an asset. For example, suppose an investor fears a global recession affecting the
economy over the next six months due to weakness in gross domestic product growth.
The investor is long multiple stocks and can mitigate some of the market risk by buying
put options in the market.

(iii) Specific risk, or diversifiable risk

It is the risk of losing an investment due to company or industry-specific hazard. Unlike

systematic risk, an investor can only mitigate against unsystematic risk through
diversification. An investor uses diversification to manage risk by investing in a variety of
assets. He can use the beta of each stock to create a diversified portfolio.

For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since the
market’s beta is always 1, the portfolio is theoretically 100% more volatile than the
market. Therefore, if the market has a 1% move up or down, the portfolio will move up
or down 2%. There is risk associated with the whole sector due to the increase in supply
of oil in the Middle East, which has caused oil to fall in price over the past few months. If
the trend continues, the portfolio will experience a significant drop in value. However,
the investor can diversify this risk since it is industry-specific.

The investor can use diversification and allocate his fund into different sectors that are
negatively correlated with the oil sector to mitigate the risk. For example, the airlines
and casino gaming sectors are good assets to invest in for a portfolio that is highly
exposed to the oil sector. Generally, as the value of the oil sector falls, the values of the
airlines and casino gaming sectors rise, and vice versa. Since airline and casino gaming
stocks are negatively correlated and have negative betas in relation to the oil sector, the
investor reduces the risks that affect his portfolio of oil stocks.

(iv) Business risk

It refers to the basic viability of a business—the question of whether a company will be

able to make sufficient sales and generate sufficient revenues to cover its operational
expenses and turn a profit. While financial risk is concerned with the costs of financing,
business risk is concerned with all the other expenses a business must cover to remain
operational and functioning. These expenses include salaries, production costs, facility
rent, and office and administrative expenses. The level of a company’s business risk is
influenced by factors such as the cost of goods, profit margins, competition, and the
overall level of demand for the products or services that it sells.

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(v) Credit or Default Risk

Credit risk is the risk that a borrower will be unable to pay the contractual interest or
principal on its debt obligations. This type of risk is particularly concerning to investors
who hold bonds in their portfolios. Government bonds, especially those issued by the
federal government, have the least amount of default risk and, as such, the lowest
returns. Corporate bonds, on the other hand, tend to have the highest amount of default
risk, but also higher interest rates. Bonds with a lower chance of default are considered
investment grade, while bonds with higher chances are considered junk bonds.
Investors can use bond rating agencies – such as Standard and Poor’s, Fitch and
Moody’s – to determine which bonds are investment-grade and which are junk.

(vi) Country Risk

Country risk refers to the risk that a country won’t be able to honor its financial
commitments. When a country defaults on its obligations, it can harm the performance
of all other financial instruments in that country – as well as other countries it has
relations with. Country risk applies to stocks, bonds, mutual funds, options and futures
that are issued within a particular country. This type of risk is most often seen in
emerging markets or countries that have a severe deficit.

(vii) Foreign-Exchange Risk

When investing in foreign countries, it’s important to consider the fact that currency
exchange rates can change the price of the asset as well. Foreign exchange risk (or
exchange rate risk) applies to all financial instruments that are in a currency other than
your domestic currency. As an example, if you live in the U.S. and invest in a Canadian
stock in Canadian dollars, even if the share value appreciates, you may lose money if
the Canadian dollar depreciates in relation to the U.S. dollar.

(viii) Interest Rate Risk

Interest rate risk is the risk that an investment’s value will change due to a change in the
absolute level of interest rates, the spread between two rates, in the shape of the yield
curve or in any other interest rate relationship. This type of risk affects the value of
bonds more directly than stocks and is a significant risk to all bondholders. As interest
rates rise, bond prices fall – and vice versa.

(ix) Political Risk

Political risk is the risk an investment’s returns could suffer because of political
instability or changes in a country. This type of risk can stem from a change in
government, legislative bodies, other foreign policy makers or military control. Also
known as geopolitical risk, the risk becomes more of a factor as an investment’s time
horizon gets longer.

(x) Counterparty Risk

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 Counterparty risk is the likelihood or probability that one of those involved in a
transaction might default on its contractual obligation. Counterparty risk can exist in
credit, investment, and trading transactions, espcially for those occurring in over-the-
counter (OTC) markets. Financial investment products such as stocks, options, bonds,
and derivatives carry counterparty risk. Bonds are rated by agencies, such as Moody’s
and Standard and Poor’s, from AAA to junk bond status to gauge the level of
counterparty risk. Bonds that carry higher counterparty risk pay higher yields.

RETURN
A return, also known as a financial return, in its simplest terms, is the money made or
lost on an investment over some period of time.

A return can be expressed nominally as the change in dollar value of an investment

over time. A return can also be expressed as a percentage derived from the ratio of
profit to investment. Returns can also be presented as net results (after fees, taxes, and
inflation) or gross returns that do not account for anything but the price change.

KEY TAKEAWAYS

• A return is the change in price on an asset, investment, or project over time, which may
be represented in terms of price change or percentage change.
• A positive return represents a profit while a negative return marks a loss.
• Returns are often annualized for comparison purposes, while a holding period return
calculates the gain or loss during the entire period an investment was held.
• Real return accounts for the effects of inflation and other external factors, while nominal
return only is interested in price change. Total return for stocks includes price change as
well as dividend and interest payments.
• Several return ratios exist for use in fundamental analysis.

Nominal Return

A nominal return is the net profit or loss of an investment expressed in nominal terms. It
can be calculated by figuring the change in value of the investment over a stated time
period plus any distributions minus any outlays. Distributions received by an investor
depend on the type of investment or venture but may include dividends, interest, rents,
rights, benefits or other cash-flows received by an investor. Outlays paid by an investor
depend on the type of investment or venture but may include taxes, costs, fees, or
expenditures paid by an investor to acquire, maintain and sell an investment.

Real Return

A real rate of return is adjusted for changes in prices due to inflation or other external
factors. This method expresses the nominal rate of return in real terms, which keeps the
purchasing power of a given level of capital constant over time. Adjusting the nominal
return to compensate for factors such as inflation allows you to determine how much of
your nominal return is real return. Knowing the real rate of return of an investment is

22
very important before investing your money. That’s because inflation can reduce the
value as time goes on, just as taxes also chip away at it.

PROFIT
Profit is a financial benefit that is realized when the amount of revenue gained from a
business activity exceeds the expenses, costs, and taxes needed to sustain the activity.
Any profit that is gained goes to the business’s owners, who may or may not decide to
spend it on the business. Profit is calculated as total revenue less total expenses.

Profit is the money a business makes after accounting for all expenses. Regardless of
whether the business is a couple of kids running a lemonade stand or a publicly traded
multinational company, consistently earning profit is every company’s goal. As a result,
much of business performance is based on profitability in its various forms.

Some analysts are interested in top-line profitability, whereas others are interested in
profitability before expenses, such as taxes and interest, and still others are only
concerned with profitability after all expenses have been paid.

There are three major types of profit that analysts analyze: gross profit, operating profit,
and net profit. Each type gives the analyst more information about a company’s
performance, especially when compared against other time periods and industry
competitors

Unit-2

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 Topic 1 Cardinal Utility Approach

The Cardinal Utility approach is propounded by neo-classical economists, who

believe that utility is measurable, and the customer can express his satisfaction in
cardinal or quantitative numbers, such as 1,2,3, and so on.

The neo-classical economist developed the theory of consumption based on the

assumption that utility is measurable and can be expressed cardinally. And to do so,
they have introduced a hypothetical unit called as “Utils” meaning the units of utility.
Here, one Util is equivalent to one rupee and the utility of money remains constant.

Over the passage of time, it was realized that the absolute measure of utility is not
possible, i.e. it was difficult to measure the feeling of satisfaction cardinally (in
numbers). Also, it was difficult to quantify the factors that cause a change in the moods
of the consumer, their tastes and preferences and their likes and dislikes. Therefore, the
utility is not measurable in quantitative terms. But however, it is being used as the
starting point in the consumer behavior analysis.

The cardinal utility approach used in analyzing the consumer behavior depends on the
following assumptions to find answers to the above-stated questions:

1. Rationality

It is assumed that the consumers are rational, and they satisfy their wants in the order
of their preference. This means they will purchase those commodities first which yields
the highest utility and then the second highest and so on.

2. Limited Resources (Money)

The consumer has limited money to spend on the purchase of goods and services and
thus this makes the consumer buy those commodities first which is a necessity.

3. Maximize Satisfaction

Every consumer aims at maximizing his/her satisfaction for the amount of money he/she
spends on the goods and services.

4. Utility is cardinally Measurable

It is assumed that the utility is measurable, and the utility derived from one unit of the
commodity is equal to the amount of money, which a consumer is ready to pay for it, i.e.
1 Util = 1 unit of money.

5. Diminishing Marginal Utility

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 This means, with the increased consumption of a commodity, the utility derived from
each successive unit goes on diminishing. This law holds true for the theory of
consumer behavior.

6. Marginal Utility of Money is Constant

It is assumed that the marginal utility of money remains constant irrespective of the level
of a consumer’s income.

7. Utility is Additive

The cardinalists believe that not only the utility is measurable but also the utility derived
from the consumption of different commodities are added up to realize the total utility.

Thus, the cardinal utility approach is used as a basis for explaining the consumer
behavior where every individual aims at maximizing his/her utility or satisfaction for the
amount of money he spends on the consumption of goods and services.

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U2 Topic 2 Diminishing Marginal Utility

The Law of Diminishing Marginal Utility states that all else equal as consumption increases
the marginal utility derived from each additional unit declines. Marginal utility is derived as the
change in utility as an additional unit is consumed. Utility is an economic term used to represent
satisfaction or happiness. Marginal utility is the incremental increase in utility that results from
consumption of one additional unit.

Marginal utility may decrease into negative utility, as it may become entirely unfavorable to
consume another unit of any product. Therefore, the first unit of consumption for any product is
typically highest, with every unit of consumption to follow holding less and less utility.

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Consumers handle the law of diminishing marginal utility by consuming numerous quantities of
numerous goods.

Example of Diminishing Marginal Utility

An individual can purchase a slice of pizza for $2; she is quite hungry and decides to buy five
slices of pizza. After doing so, the individual consumes the first slice of pizza and gains a certain
positive utility from eating the food. Because the individual was hungry and this is the first food
she consumed, the first slice of pizza has a high benefit. Upon consuming the second slice of
pizza, the individual’s appetite is becoming satisfied. She wasn’t as hungry as before, so the
second slice of pizza had a smaller benefit and enjoyment as the first. The third slice, as before,
holds even less utility as the individual is now not hungry anymore.

In fact, the fourth slice of pizza has experienced a diminished marginal utility as well, as it is
difficult to be consumed because the individual experiences discomfort upon being full from
food. Finally, the fifth slice of pizza cannot even be consumed. The individual is so full from the
first four slices that consuming the last slice of pizza results in negative utility. The five slices of
pizza demonstrate the decreasing utility that is experienced upon the consumption of any good.
In a business application, a company may benefit from having three accountants on its staff.
However, if there is no need for another accountant, hiring a fourth accountant results in a
diminished utility, as little benefit is gained from the new hire.

This law can be stated thus:

“The more one consumes of one commodity during any period of time the less satisfaction one
gets from consuming an additional unit of it”.

As one adds to his (her) weekly consumption of chocolate, each additional unit adds to his TU or
total satisfaction, but each unit adds less utility than the one before it.

Utility schedule presented in Table 4.1 can be represented diagrammatically. See Fig. 4.1. In Fig.
4.1 our representative consumer Mr. John is seen to add to his total satisfaction as he increases
weekly purchase of chocolate until he is buying 5 units (bars) per day. A 6th bar per week gives
him disutility or dissatisfaction.

Fig. 4.2 (which is derived from Fig. 4.1) illustrates the Law of Diminishing MU. This indicates
that the additions to TU of chocolate became less as more bars per day are purchased. It is clear
that the MU of the six bars per day is negative, i.e., the sixth bar causes a decrease in TU.

27
 Assumptions of the Law
The Law of Diminishing Marginal Utility is based on the assumptions:

1. The utility that a consumer gets can be measured and expressed in numbers (utils).
Moreover, the units of the commodity must be properly defined.
2. The maximum price a consumer is ready to pay for the commodity depends on its
marginal utility to him.
3. The taste and preference of the consumer remain unchanged during the period of
purchases.
4. The initial amount of consumption is sufficient to give the consumer full satisfaction.

Causes of Diminishing Marginal Utility:

Three important causes of the diminishing marginal utility are:

1. Satisfaction of a Particular Want

Although human wants are unlimited, a particular want is limited. So it can be satisfied.
As a person consumes more and more of a commodity, his indication becomes less and
less. So his marginal utility from the successive units becomes gradually smaller. It
means that too many units of a commodity bring complete satisfaction.

2. Introspection

The validity of the law can be established through introspection (i.e., an examination of
one’s own thought or mental reaction). The classical economists used to look into their
minds for their own psychological reaction to the extra consumption of a particular thing
(say, an apple, an ice-cream, a chocolate, etc.) and tested the truth of the law.

3. Less Important Uses of Additional Quantities

Furthermore, marginal utility diminishes because a person, having several units of a

commodity capable of alternative uses, puts one unit to its most important use and the
additional units to the successively less important uses.

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 Limitations of the Law
The Law may not operate in certain circumstances and in those exceptional cases the
marginal utility of a thing may increase for some time.

Six important exceptional cases to the law are:

1. Change of Taste and Preferences

If a consumer’s taste changes so that he likes a commodity more, the marginal utility of
any quantity of that commodity rises. A person may not have initially any interest in
eating egg roll. But after taking one egg roll, he may form a good taste for it and may get
a great satisfaction from the 2nd or the 3rd one.

2. Inadequate Initial Consumption

If a person consumes a very small quantity of a particular thing at the initial stage, he
may not get full satisfaction from it. In such a case his satisfaction will be greater from
the second unit. Thus, coke in a small glass may not quench one’s thirst at all, as such,
the satisfaction from the second one is likely to be greater.

3. Emotional or Fancy Buying

The marginal utility of a thing does not diminish when a buyer purchases it in a larger
quantity out of sheer emotion or fancy. An example is the art work of a known painter or
a rare book of a dead author.

4. Miser’s Collections or Hobby Collections

A miser gets a greater satisfaction from the additional collection of money. Similarly, a
person gets more and more satisfaction as his hobby-collections (e.g., stamps, coins,
works of art, etc.) increase gradually.

5. Consumption at Different Time Periods

If a person consumes different units of a particular thing at different times, the marginal
utility from the successive units is not likely to be smaller. Thus, if he consumes the 1st
ice-cream in the morning, the 2nd in the afternoon and the 3rd at night, the marginal
utility may not diminish.

6. Stock with Other Persons

Sometimes the utility of a thing depends on its stock with the others. If in a locality all
but one have two cars, the second car to that man will not yield diminishing utility.

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Topic 3 Law of Equi-Marginal Utility
THEINTACTFRONT3 MONTHS AGO 3 COMMENTS

The Law of equimarginal Utility is another fundamental principle of Economics.

This law is also known as the Law of substitution or the Law of Maximum Satisfaction.

We know that human wants are unlimited whereas the means to satisfy these wants are strictly
limited. It, therefore’ becomes necessary to pick up the most urgent wants that can be satisfied
with the money that a consumer has. Of the things that he decides to buy he must buy just the
right quantity. Every prudent consumer will try to make the best use of the money at his disposal
and derive the maximum satisfaction.

Explanation of the Law

In order to get maximum satisfaction out of the funds we have, we carefully weigh the
satisfaction obtained from each rupee ‘had we spend If we find that a rupee spent in one
direction has greater utility than in another, we shall go on spending money on the former
commodity, till the satisfaction derived from the last rupee spent in the two cases is equal.

It other words, we substitute some units of the commodity of greater utility tor some units of the
commodity of less utility. The result of this substitution will be that the marginal utility of the
former will fall and that of the latter will rise, till the two marginal utilities are equalized. That is
why the law is also called the Law of Substitution or the Law of equimarginal Utility.

Suppose apples and oranges are the two commodities to be purchased. Suppose further that we
have got seven rupees to spend. Let us spend three rupees on oranges and four rupees on apples.
What is the result? The utility of the 3rd unit of oranges is 6 and that of the 4th unit of apples is
2. As the marginal utility of oranges is higher, we should buy more of oranges and less of apples.
Let us substitute one orange for one apple so that we buy four oranges and three apples.

Now the marginal utility of both oranges and apples is the same, i.e., 4. This arrangement yields
maximum satisfaction. The total utility of 4 oranges would be 10 + 8 + 6 + 4 = 28 and of three
apples 8 + 6 + 4= 18 which gives us a total utility of 46. The satisfaction given by 4 oranges and
3 apples at one rupee each is greater than could be obtained by any other combination of apples
and oranges. In no other case does this utility amount to 46. We may take some other
combinations and see.

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We thus come to the conclusion that we obtain maximum satisfaction when we equalize
marginal utilities by substituting some units of the more useful for the less useful
commodity. We can illustrate this principle with the help of a diagram.

Diagrammatic Representation:

In the two figures given below, OX and OY are the two axes. On X-axis OX are
represented the units of money and on the Y-axis marginal utilities. Suppose a person
has 7 rupees to spend on apples and oranges whose diminishing marginal utilities are
shown by the two curves AP and OR respectively.

The consumer will gain maximum satisfaction if he spends OM money (3 rupees) on

apples and OM’ money (4 rupees) on oranges because in this situation the marginal
utilities of the two are equal (PM = P’M’). Any other combination will give less total
satisfaction.

Let the purchase spend MN money (one rupee) more on apples and the same amount
of money, N’M'( = MN) less on oranges. The diagram shows a loss of utility represented
by the shaded area LN’M’P’ and a gain of PMNE utility. As MN = N’M’ and PM=P’M’, it
is proved that the area LN’M’P’ (loss of utility from reduced consumption of oranges) is
bigger than PMNE (gain of utility from increased consumption of apples). Hence the
total utility of this new combination is less.

We then, conclude that no other combination of apples and oranges gives as great a
satisfaction to the consumer as when PM = P’M’, i.e., where the marginal utilities of
apples and oranges purchased are equal, with given amour, of money at our disposal.

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Limitations of the Law of Equimarginal Utility
Like other economic laws, the law of equimarginal utility too has certain limitations or
exceptions. The following are the main exception.

(i) Ignorance
If the consumer is ignorant or blindly follows custom or fashion, he will make a wrong
use of money. On account of his ignorance he may not know where the utility is greater
and where less. Thus, ignorance may prevent him from making a rational use of money.
Hence, his satisfaction may not be the maximum, because the marginal utilities from his
expenditure cannot be equalised due to ignorance.

(ii) Inefficient Organisation

In the same manner, an incompetent organiser of business will fail to achieve the best
results from the units of land, labour and capital that he employs. This is so because he
may not be able to divert expenditure to more profitable channels from the less
profitable ones.

(iii) Unlimited Resources

The law has obviously no place where this resources are unlimited, as for example, is
the case with the free gifts of nature. In such cases, there is no need of diverting
expenditure from one direction to another.

(iv) Hold of Custom and Fashion

A consumer may be in the strong clutches of custom, or is inclined to be a slave of
fashion. In that case, he will not be able to derive maximum satisfaction out of his
expenditure, because he cannot give up the consumption of such commodities. This is
specially true of the conventional necessaries like dress or when a man is addicted to
some intoxicant.

(v) Frequent Changes in Prices

Frequent changes in prices of different goods render the observance of the law very
difficult. The consumer may not be able to make the necessary adjustments in his
expenditure in a constantly changing price situation.

Topic 4 Ordinal Utility Approach

The basic idea behind ordinal utility approach is that a consumer keeps number of pairs
of two commodities in his mind which give him equal level of satisfaction. This means
that the utility can be ranked qualitatively.

The ordinal utility approach differs from the cardinal utility approach (also called
classical theory) in the sense that the satisfaction derived from various commodities
cannot be measured objectively.

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 Ordinal theory is also known as neo-classical theory of consumer equilibrium, Hicksian
theory of consumer behavior, indifference curve theory, optimal choice theory. This
approach also explains the consumer’s equilibrium who is confronted with the
multiplicity of objectives and scarcity of money income.

The important tools of ordinal utility are:

• The concept of indifference curves.

• The slop of I.C. i.e. marginal rate of substitution.
• The budget line.

Assumptions of Ordinal Utility Approach

1. Rationality

It is assumed that the consumer is rational who aims at maximizing his level of
satisfaction for given income and prices of goods and services, which he wish to
consume. He is expected to take decisions consistent with this objective.

2. Ordinal Utility

The indifference curve assumes that the utility can only be expressed ordinally. This
means the consumer can only tell his order of preference for the given goods and
services.

3. Transitivity and Consistency of Choice

The consumer’s choice is expected to be either transitive or consistent. The transitivity

of choice means, if the consumer prefers commodity X to Y and Y to Z, then he must
prefer commodity X to Z. In other words, if X= Y, Y = Z, then he must treat X=Z. The
consistency of choice means that if a consumer prefers commodity X to Y at one point
of time, he will not prefer commodity Y to X in another period or even will not consider
them as equal.

4. Nonsatiety

It is assumed that the consumer has not reached the saturation point of any commodity
and hence, he prefers larger quantities of all commodities.

5. Diminishing Marginal Rate of Substitution (MRS)

The marginal rate of substitution refers to the rate at which the consumer is ready to
substitute one commodity (A) for another commodity (B) in such a way that his total
satisfaction remains unchanged. The MRS is denoted as DB/DA. The ordinal approach
assumes that DB/DA goes on diminishing if the consumer continues to substitute A for
B.

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 Topic 5 Indifference Curves
An indifference curve is a graph showing combination of two goods that give the
consumer equal satisfaction and utility. Each point on an indifference curve indicates
that a consumer is indifferent between the two and all points give him the same utility.

Indifference Map
An Indifference Map is a set of Indifference Curves. It depicts the complete picture of a
consumer’s preferences. The following diagram showing an indifference map consisting
of three curves:

We know that a consumer is indifferent among the combinations lying on the same
indifference curve. However, it is important to note that he prefers the combinations on
the higher indifference curves to those on the lower ones.

This is because a higher indifference curve implies a higher level of satisfaction.

Therefore, all combinations on IC1 offer the same satisfaction, but all combinations on
IC2 give greater satisfaction than those on IC1.

Properties of an Indifference Curve or IC

Here are the properties of an indifference curve:

1. An IC slopes downwards to the right

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 This slope signifies that when the quantity of one commodity in combination is
increased, the amount of the other commodity reduces. This is essential for the level of
satisfaction to remain the same on an indifference curve.

2. An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food,
he is willing to part with less and less of clothing. This is the diminishing marginal rate of
substitution. The rate gives a convex shape to the indifference curve. However, there
are two extreme scenarios:

• Two commodities are perfect substitutes for each other – In this case, the indifference
curve is a straight line, where MRS is constant.
• Two goods are perfect complementary goods – An example of such goods would be
gasoline and water in a car. In such cases, the IC will be L-shaped and convex to the
origin.

3. Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other
either. Look at the following diagram:

Fig shows two ICs intersecting each other at point A. Since A and B lie on IC1, the give
the same satisfaction level. Similarly, A and C give the same satisfaction level, as they
lie on IC2. Therefore, we can imply that B and C offer the same level of satisfaction,
which is logically absurd. Hence, no tow ICs can touch or intersect each other.

4. A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

5. An IC does not touch the axis

35
 This is not possible because of our assumption that a consumer considers different
combinations of two commodities and wants both of them. If the curve touches either of
the axes, then it means that he is satisfied with only one commodity and does not want
the other, which is contrary to our assumption.

Topic 6 Marginal rate of Substitution

In economics, the marginal rate of substitution (MRS) is the amount of a good that a
consumer is willing to give up for another good, as long as the new good is equally
satisfying. It’s used in indifference theory to analyze consumer behavior. The marginal
rate of substitution is calculated between two goods placed on an indifference curve,
displaying a frontier of equal utility for each combination of “good A” and “good B.”

• The marginal rate of substitution (MRS) is the amount of a good that a consumer is
willing to give up for another good, as long as the new good is equally satisfying.
• It forms a downward sloping curve, called the indifference curve.
• At any given point along an indifference curve, the MRS is the slope of the indifference
curve at that point.

What Does the Marginal Rate of Substitution Tell You?

The marginal rate of substitution is an economics term that refers to the point at
which one good is substitutable for another. It forms a downward sloping curve,
called the indifference curve, where each point along it represents quantities of
good X and good Y that you would be happy substituting for one another. It is
always changing for a given point on the curve, and mathematically represents
the slope of the curve at that point.

At any given point along an indifference curve, the MRS is the slope of the
indifference curve at that point. Note that most indifference curves are actually
curves, so their slopes are changing as you move along them. If the marginal
rate of substitution of X for Y or Y for X is diminishing, the indifference’ curve
must be convex to the origin. If it is constant, the indifference curve will be a
straight line sloping downwards to the right at a 45° angle to either axis. If the
marginal rate of substitution is increasing, the indifference curve will be concave
to the origin.

The law of diminishing marginal rates of substitution states that MRS decreases
as one moves down the standard convex-shaped curve, which is the indifference
curve.

Limitations of Marginal Rate of Substitution

• The marginal rate of substitution does not examine a combination of goods that a
consumer would prefer more or less than another combination but examines
which combinations of goods the consumer would prefer just as much. It also

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 does not examine marginal utility – how much better or worse off a consumer
would be with one combination of goods rather than another – because all
combinations of goods along the indifference curve are valued the same by the
consumer.

Topic 7 Budget Line and Consumer Equilibrium

Budget Line
Definition: The Budget Line, also called as Budget Constraint shows all the
combinations of two commodities that a consumer can afford at given market prices and
within the particular income level.

We know that the higher the indifference curve, the higher is the utility, and thus, utility
maximizing consumer will strive to reach the highest possible Indifference curve. But, he
has two strong constraints: limited income and given the market price of goods and
services. The income in hand is the main constraint (budgetary) that decides how high a
consumer can go on the indifference map. In a two commodity model, the budgetary
constraint can be expressed in the form of the budget equation:

Px . Qx + Py . Qy =M

Where,

Px and Py are the prices of commodity X and Y and Qx, and Qy is their respective
quantities.

M= consumer’s money income

The Budget equation states that the consumer’s expenditure on commodity X and Y
cannot exceed his money income (M). Thus, the quantities of commodities X and Y that
a consumer can buy from his income (M) at given prices Px and Py can be calculated
through the budget equation given below:

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 The values of Qx and Qy are plotted on the X and Y axis, and a line with a negative
slope is drawn connecting the points so obtained. This line is called the budget line or
price line.

Consumers Equilibrium
A consumer is in equilibrium when he derives maximum satisfaction from the goods and
is in no position to rearrange his purchases.

Assumptions of Consumers Equilibrium

• There is a defined indifference map showing the consumer’s scale of preferences

across different combinations of two goods X and Y.
• The consumer has a fixed money income and wants to spend it completely on the
goods X and Y.
• The prices of the goods X and Y are fixed for the consumer.
• The goods are homogenous and divisible.
• The consumer acts rationally and maximizes his satisfaction.

n order to display the combination of two goods X and Y, that the consumer buys to be
in equilibrium, let’s bring his indifference curves and budget line together.

We know that,

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• Indifference Map: shows the consumer’s preference scale between various
combinations of two goods
• Budget Line: depicts various combinations that he can afford to buy with his money
income and prices of both the goods.

In the following figure, we depict an indifference map with 5 indifference curves – IC1,
IC2, IC3, IC4, and IC5 along with the budget line PL for good X and good Y.

From the figure, we can see that the combinations R, S, Q, T, and H cost the same to
the consumer. In order to maximize his level of satisfaction, the consumer will try to
reach the highest indifference curve. Since we have assumed a budget constraint, he
will be forced to remain on the budget line.

Topic 8 Theory of Demand, Law of Demand

3 COMMENTS
Theory of Demand
Demand theory is a principle relating to the relationship between consumer demand for goods
and services and their prices. Demand theory forms the basis for the demand curve, which relates
consumer desire to the amount of goods available. As more of a good or service is available,
demand drops and so does the equilibrium price.

Demand is the quantity of a good or service that consumers are willing and able to buy at a given
price in a given time period. People demand goods and services in an economy to satisfy their
wants, such as food, healthcare, clothing, entertainment, shelter, etc. The demand for a product at
a certain price reflects the satisfaction that an individual expects from consuming the product.
This level of satisfaction is referred to as utility and it differs from consumer to consumer. The
demand for a good or service depends on two factors:

(1) Its utility to satisfy a want or need, and

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(2) The consumer’s ability to pay for the good or service. In effect, real demand is when the
readiness to satisfy a want is backed up by the individual’s ability and willingness to pay.

Built into demand are factors such as consumer preferences, tastes, choices, etc. Evaluating
demand in an economy is, therefore, one of the most important decision-making variables that a
business must analyze if it is to survive and grow in a competitive market. The market system is
governed by the laws of supply and demand, which determine the prices of goods and services.
When supply equals demand, prices are said to be in a state of equilibrium. When demand is
higher than supply, prices increase to reflect scarcity. Conversely, when demand is lower than
supply, prices fall due to the surplus.

The law of demand introduces an inverse relationship between price and demand for a good or
service. It simply states that as the price of a commodity increases, demand decreases, provided
other factors remain constant. Also, as the price decreases, demand increases. This relationship
can be illustrated graphically using a tool known as the demand curve.

The demand curve has a negative slope as it charts downward from left to right to reflect the
inverse relationship between the price of an item and the quantity demanded over a period of
time. An expansion or contraction of demand occurs as a result of the income effect or
substitution effect. When the price of a commodity falls, an individual can get the same level of
satisfaction for less expenditure, provided it’s a normal good. In this case, the consumer can
purchase more of the goods on a given budget. This is the income effect. The substitution effect
is observed when consumers switch from more costly goods to substitutes that have fallen in
price. As more people buy the good with the lower price, demand increases.

Sometimes, consumers buy more or less of a good or service due to factors other than price. This
is referred to as a change in demand. A change in demand refers to a shift in the demand curve to
the right or left following a change in consumers’ preferences, taste, income, etc. For example, a
consumer who receives an income raise at work will have more disposable income to spend on
goods in the markets, regardless of whether prices fall, leading to a shift to the right of the
demand curve.

The law of demand is violated when dealing with Giffen or inferior goods. Giffen goods are
inferior goods that people consume more of as prices rise, and vice versa. Since a Giffen good
does not have easily available substitutes, the income effect dominates the substitution effect.

Demand theory is one of the core theories of microeconomics. It aims to answer basic questions
about how badly people want things, and how demand is impacted by income levels and
satisfaction (utility). Based on the perceived utility of goods and services by consumers,
companies adjust the supply available and the prices charged.

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 Law of Demand
The law of demand is one of the most fundamental concepts in economics. It works with
the law of supply to explain how market economies allocate resources and determine
the prices of goods and services that we observe in everyday transactions. The law of
demand states that quantity purchased varies inversely with price. In other words, the
higher the price, the lower the quantity demanded. This occurs because of diminishing
marginal utility. That is, consumers use the first units of an economic good they
purchase to serve their most urgent needs first, and use each additional unit of the good
to serve successively lower valued ends.

• The law of demand is a fundamental principle of economics which states that at a

higher price consumers will demand a lower quantity of a good.
• Demand is derived from the law of diminishing marginal utility, the fact that consumers
use economic goods to satisfy their most urgent needs first.
• A market demand curve expresses the sum of quantity demanded at each price across
all consumers in the market.
• Changes in price can be reflected in movement along a demand curve, but do not by
themselves increase or decrease demand.
• The shape and magnitude of demand shifts in response to changes in consumer
preferences, incomes, or related economic goods, NOT to changes in price.

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Understanding the Law of Demand

Economics involves the study of how people use limited means to satisfy unlimited
wants. The law of demand focuses on those unlimited wants. Naturally, people prioritize
more urgent wants and needs over less urgent ones in their economic behavior, and
this carries over into how people choose among the limited means available to them.
For any economic good, the first unit of that good that a consumer gets their hands on
will tend to be put to use to satisfy the most urgent need the consumer has that that
good can satisfy.

For example, consider a castaway on a desert island who obtains a six pack of bottled,
fresh water washed up on shore. The first bottle will be used to satisfy the castaway’s
most urgently felt need, most likely drinking water to avoid dying of thirst. The second
bottle might be used for bathing to stave off disease, an urgent but less immediate
need. The third bottle could be used for a less urgent need such as boiling some fish to
have a hot meal, and on down to the last bottle, which the castaway uses for a relatively
low priority like watering a small potted plant to keep him company on the island.

In our example, because each additional bottle of water is used for a successively less
highly valued want or need by our castaway, we can say that the castaway values each
additional bottle less than the one before. Similarly, when consumers purchase goods
on the market each additional unit of any given good or service that they buy will be put
to a less valued use than the one before, so we can say that they value each additional
unit less and less. Because they value each additional unit of the good less, they are
willing to pay less for it. So the more units of a good consumers buy, the less they are
willing to pay in terms of the price.

By adding up all the units of a good that consumers are willing to buy at any given price
we can describe a market demand curve, which is always downward-sloping, like the
one shown in the chart below. Each point on the curve (A, B, C) reflects the quantity
demanded (Q) at a given price (P). At point A, for example, the quantity demanded is
low (Q1) and the price is high (P1). At higher prices, consumers demand less of the
good, and at lower prices, they demand more.

Factors Affecting Demand

So what does change demand? The shape and position of the demand curve can be
impacted by several factors. Rising incomes tend to increase demand for normal
economic goods, as people are willing to spend more. The availability of close
substitute products that compete with a given economic good will tend to reduce
demand for that good, since they can satisfy the same kinds of consumer wants and
needs. Conversely, the availability of closely complementary goods will tend to increase
demand for an economic good, because the use of two goods together can be even
more valuable to consumers than using them separately, like peanut butter and jelly.
Other factors such as future expectations, changes in background environmental
conditions, or change in the actual or perceived quality of a good can change the

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demand curve, because they alter the pattern of consumer preferences for how the
good can be used and how urgently it is needed.

Topic 9 Movement along vs. Shift in Demand Curve

While understanding the meaning and analysis of a demand curve in the study of
Economics, it is also important to be able to make a distinction between the movement
and shift of the demand curve. In this article, we will look at ways by which you can
understand the difference between a movement along a demand curve and shift of the
demand curve.

Movement along the Demand Curve and Shift of the Demand Curve

Every firm faces a certain demand curve for the goods it supplies. There are many
factors that affect the demand and these effects can be seen by observing the changes
in the demand curve. Broadly speaking, the factors can be categorized into two types:

(i) Change in demand

(ii) Change in the quantity demanded

Movement of the Demand Curve

When there is a change in the quantity demanded of a particular commodity, because of

a change in price, with other factors remaining constant, there is a movement of the
quantity demanded along the same curve.

The important aspect to remember is that other factors like the consumer’s income and
tastes along with the prices of other goods, etc. remain constant and only the price of
the commodity changes.

In such a scenario, the change in price affects the quantity demanded but the demand
follows the same curve as before the price changes. This is Movement of the Demand
Curve. The movement can occur either in an upward or downward direction along the
demand curve.

We know that if all other factors remain constant, then an increase in the price of a
commodity decreases its demand. Also, a decrease in the price increases the demand.
So, what happens to the demand curve?

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 In Fig. 1 above, we can see that when the price of a commodity is OP, its demand is
OM (provided other factors are constant). Now, let’s look at the effect of an increase
and decrease in price on the demand:

• When the price increases from OP to OP”, the quantity demanded falls to OL. Also, the
demand curve moves UPWARD.
• When the price decreases from OP to OP’, the quantity demanded rises to ON. Also,
the demand curve moves DOWNWARD.

Therefore, we can see that a change in price, with other factors remaining constant
moves the demand curve either up or down.

The shift of the Demand Curve

When there is a change in the quantity demanded of a particular commodity, at each

possible price, due to a change in one or more other factors, the demand curve shifts.
The important aspect to remember is that other factors like the consumer’s income and
tastes along with the prices of other goods, etc., which were expected to remain
constant, changed.

In such a scenario, the change in price, along with a change in one/more other factors,
affects the quantity demanded. Therefore, the demand follows a different curve for
every price change.

This is the Shift of the Demand Curve. The demand curve can shift either to the left or
the right, depending on the factors affecting it.

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 Topic 10 Concept of Measurement of Elasticity of Demand

The following points highlight the top five methods used for measuring the elasticity of
demand. The methods are:

1. Price Elasticity of Demand

2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertisement or Promotional Elasticity of Sales
5. Elasticity of Price Expectations

Method # 1. Price Elasticity of Demand

Price elasticity of demand is a measure of the responsiveness of demand to changes in

the commodity’s own price. It is the ratio of the relative change in a dependent variable
(quantity demanded) to the relative change in an independent variable (Price). In other
words, price elasticity is the ratio of a relative change in quantity demanded to a relative
change in price.

Also, elasticity is the percentage change in quantity demanded divided by the

percentage in price.

Symbolically, we may rewrite the formula:

If percentages are known, the numerical value of elasticity can be calculated. The
coefficient of elasticity of demand is a pure number i.e. it stands by itself, being
independent of units of measurement. The coefficient of price elasticity of demand can
be calculated with the help of the following formula.

Q is quantity, P is price, ΔQ/Q relative change in the quantity demanded and ΔP/P
Relative change in price.

It should be noted that a minus sign (-) is generally inserted in the formula before the
fraction with a view to making the coefficient of elasticity a non-negative value.

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The price elasticity can be measured between two finite points on a demand curve
(called arc elasticity) or on a point (called point elasticity).

Method # 2. Income Elasticity of Demand

The responsiveness of quantity demanded to changes in income is called income

elasticity of demand. With income elasticity, consumer incomes vary while tastes, the
commodity’s own price, and the other prices are held constant.

The income elasticity of demand for a good or service may be calculated by the formula:

where- ey stands for the coefficient of income elasticity, Y for income.

Whereas price-elasticity of demand is always negative, income-elasticity of demand is

always positive (except for inferior goods) as the relationship between income and
quantity demanded of a product is positive. For inferior goods the income elasticity of
demand is negative because as income increases, consumers switch over to the
consumption of superior substitutes.

Method # 3. Cross Elasticity of Demand

Demand is also influenced by prices of other goods and services. The cross elasticity
measures the responsiveness of quantity demanded to changes in price of other goods
and services. Cross elasticity of demand is defined as the percentage change in
quantity demanded of one good caused by a 1 percentage change in the price of some
other good.

Cross elasticity is used to classify the relationship between goods. If cross elasticity is
greater than zero, an increase in the price of y causes an increase in the quantity
demanded of x, and the two products are said to be substitutes. When the cross-
elasticity is greater than zero, the goods or services involved are classified as
complements Increases in the price of y reduces the quantity demanded of that product.
Diminished demand for y causes a reduced demand for x. Bread and butter, cars and
tires, and computers and computer programs are examples of pairs of goods that are
complements.

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 The coefficient is positive if A and B are substitutes because the price change and the
quantity change are in the same direction. The coefficient is negative if A and B are
complements, because changes in the price of one commodity cause opposite changes
in the quantity demanded of the other. Other things such as consumer taste for both
commodities, consumer incomes and the price of the other commodity are held
constant.

Method # 4. Advertisement or Promotional Elasticity of Sales

The advertisement expenditure helps in promoting sales. The impact of advertisement

on sales is not uniform at all level of total sales. The concept of advertising elasticity is
significant in determining the optimum level of advertisement outlay particularly in view
of competitive advertising by rival firms. An advertising elasticity could be defined as the
percentage change in quantity demanded for a percentage change in advertising.
Advertising might be measured by expenditure.

Advertising elasticity may be measured by the following formula:

Method # 5. Elasticity of Price Expectations

People’s price expectations also play a significant role as a determinant of demand. J.R.
Hicks, the English economist, in 1939, devised the concept of elasticity of price
expectations. The elasticity of price expectations may be defined as the ratio of the
relative change in expected future prices to the relative change in current prices.

Topic 11 Factors affecting Elasticity of Demand

9 Major Factors which Affects the Elasticity of Demand of a Commodity

1. Nature of commodity

Elasticity of demand of a commodity is influenced by its nature. A commodity for a

person may be a necessity, a comfort or a luxury.

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 (i) When a commodity is a necessity like food grains, vegetables, medicines, etc., its
demand is generally inelastic as it is required for human survival and its demand does
not fluctuate much with change in price.

(ii) When a commodity is a comfort like fan, refrigerator, etc., its demand is generally
elastic as consumer can postpone its consumption.

(iii) When a commodity is a luxury like AC, DVD player, etc., its demand is generally
more elastic as compared to demand for comforts.

(iv) The term ‘luxury’ is a relative term as any item (like AC), may be a luxury for a poor
person but a necessity for a rich person.

2. Availability of substitutes

Demand for a commodity with large number of substitutes will be more elastic. The
reason is that even a small rise in its prices will induce the buyers to go for its
substitutes. For example, a rise in the price of Pepsi encourages buyers to buy Coke
and vice-versa.

Thus, availability of close substitutes makes the demand sensitive to change in the
prices. On the other hand, commodities with few or no substitutes like wheat and salt
have less price elasticity of demand.

3. Income Level

Elasticity of demand for any commodity is generally less for higher income level groups
in comparison to people with low incomes. It happens because rich people are not
influenced much by changes in the price of goods. But, poor people are highly affected
by increase or decrease in the price of goods. As a result, demand for lower income
group is highly elastic.

4. Level of price

Level of price also affects the price elasticity of demand. Costly goods like laptop,
Plasma TV, etc. have highly elastic demand as their demand is very sensitive to
changes in their prices. However, demand for inexpensive goods like needle, match
box, etc. is inelastic as change in prices of such goods do not change their demand by a
considerable amount.

5. Postponement of Consumption

Commodities like biscuits, soft drinks, etc. whose demand is not urgent, have highly
elastic demand as their consumption can be postponed in case of an increase in their
prices. However, commodities with urgent demand like life saving drugs, have inelastic
demand because of their immediate requirement.

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6. Number of Uses

If the commodity under consideration has several uses, then its demand will be elastic.
When price of such a commodity increases, then it is generally put to only more urgent
uses and, as a result, its demand falls. When the prices fall, then it is used for satisfying
even less urgent needs and demand rises.

For example, electricity is a multiple-use commodity. Fall in its price will result in
substantial increase in its demand, particularly in those uses (like AC, Heat convector,
etc.), where it was not employed formerly due to its high price. On the other hand, a
commodity with no or few alternative uses has less elastic demand.

7. Share in Total Expenditure

Proportion of consumer’s income that is spent on a particular commodity also influences

the elasticity of demand for it. Greater the proportion of income spent on the commodity,
more is the elasticity of demand for it and vice-versa.

Demand for goods like salt, needle, soap, match box, etc. tends to be inelastic as
consumers spend a small proportion of their income on such goods. When prices of
such goods change, consumers continue to purchase almost the same quantity of these
goods. However, if the proportion of income spent on a commodity is large, then
demand for such a commodity will be elastic.

8. Time Period

Price elasticity of demand is always related to a period of time. It can be a day, a week,
a month, a year or a period of several years. Elasticity of demand varies directly with the
time period. Demand is generally inelastic in the short period.

It happens because consumers find it difficult to change their habits, in the short period,
in order to respond to a change in the price of the given commodity. However, demand
is more elastic in long rim as it is comparatively easier to shift to other substitutes, if the
price of the given commodity rises.

9. Habits

Commodities, which have become habitual necessities for the consumers, have less
elastic demand. It happens because such a commodity becomes a necessity for the
consumer and he continues to purchase it even if its price rises. Alcohol, tobacco,
cigarettes, etc. are some examples of habit forming commodities.

Topic 12 Income Elasticity of Demand

Income elasticity of demand refers to the sensitivity of the quantity demanded for a
certain good to a change in real income of consumers who buy this good, keeping all

49
other things constant. The formula for calculating income elasticity of demand is the
percent change in quantity demanded divided by the percent change in income.

Income elasticity of demand measures the responsiveness of demand for a particular

good to changes in consumer income. The higher the income elasticity of demand in
absolute terms for a particular good, the bigger consumers’ response in their purchasing
habits — if their real income changes. Businesses typically evaluate income elasticity of
demand for their products to help predict the impact of a business cycle on product
sales.

Calculation of Income Elasticity of Demand

Consider a local car dealership that gathers data on changes in demand and consumer
income for its cars for a particular year. When the average real income of its customers
falls from $50,000 to $40,000, the demand for its cars plummets from 10,000 to 5,000
units sold, all other things unchanged. The income elasticity of demand is calculated by
taking a negative 50% change in demand, a drop of 5,000 divided by the initial demand
of 10,000 cars, and dividing it by a 20% change in real income — the $10,000 change in
income divided by the initial value of $50,000. This produces an elasticity of 2.5, which
indicates local customers are particularly sensitive to changes in their income when it
comes to buying cars.

Interpretation of Income Elasticity of Demand

Depending on the values of the income elasticity of demand, goods can be broadly
categorized as inferior goods and normal goods. Normal goods have a positive income
elasticity of demand; as incomes rise, more goods are demanded at each price level.
Normal goods whose income elasticity of demand is between zero and one are typically
referred to as necessity goods, which are products and services that consumers will buy
regardless of changes in their income levels. Examples of necessity goods and services
include tobacco products, haircuts, water and electricity. As income rises, the proportion
of total consumer expenditures on necessity goods typically declines. Inferior goods
have a negative income elasticity of demand; as consumers’ income rises, they buy
fewer inferior goods. A typical example of such type of product is margarine, which is
much cheaper than butter.

Luxury goods represent normal goods associated with income elasticities of demand
greater than one. Consumers will buy proportionately more of a particular good
compared to a percentage change in their income. Consumer discretionary products
such as premium cars, boats and jewelry represent luxury products that tend to be very
sensitive to changes in consumer income. When a business cycle turns downward,
demand for consumer discretionary goods tends to drop as workers become
unemployed.

Basically, a negative income elasticity of demand is linked with inferior goods, meaning
rising incomes will lead to a drop in demand and may mean changes to luxury goods. A
positive income elasticity of demand is linked with normal goods. In this case, a rise in
income will lead to a rise in demand.
Types of Income Elasticity of Demand

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There are five types of income elasticity of demand:

(i) High

A rise in income comes with bigger increases in the quantity demanded.

(ii) Unitary

The rise in income is proportionate to the increase in the quantity demanded.

(iii) Low

A jump in income is less than proportionate than the increase in the quantity demanded.

(iv) Zero

The quantity bought/demanded is the same even if income changes

(v) Negative

An increase in income comes with a decrease in the quantity demanded.

Topic 13 Cross Elasticity of Demand

The cross elasticity of demand is an economic concept that measures the
responsiveness in the quantity demanded of one good when the price for another good
changes. Also called cross-price elasticity of demand, this measurement is calculated
by taking the percentage change in the quantity demanded of one good and dividing it
by the percentage change in the price of the other good.

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 Substitute Goods
The cross elasticity of demand for substitute goods is always positive because the
demand for one good increases when the price for the substitute good increases. For
example, if the price of coffee increases, the quantity demanded for tea (a substitute
beverage) increases as consumers switch to a less expensive yet substitutable
alternative. This is reflected in the cross elasticity of demand formula, as both the
numerator (percentage change in the demand of tea) and denominator (the price of
coffee) show positive increases.

Items with a coefficient of 0 are unrelated items and are goods independent of each
other. Items may be weak substitutes, in which the two products have a positive but low
cross elasticity of demand. This is often the case for different product substitutes, such
as tea versus coffee. Items that are strong substitutes have a higher cross-elasticity of
demand. Consider different brands of tea; a price increase in one company’s green tea
has a higher impact on another company’s green tea demand.

Complementary Goods
Alternatively, the cross elasticity of demand for complementary goods is negative. As
the price for one item increases, an item closely associated with that item and
necessary for its consumption decreases because the demand for the main good has
also dropped.

For example, if the price of coffee increases, the quantity demanded for coffee stir sticks
drops as consumers are drinking less coffee and need to purchase fewer sticks. In the
formula, the numerator (quantity demanded of stir sticks) is negative and the
denominator (the price of coffee) is positive. This results in a negative cross elasticity.

Toothpaste is an example of a substitute good; if the price of one brand of toothpaste

increases, the demand for a competitor’s brand of toothpaste increases in turn.

KEY TAKEAWAYS

• The cross elasticity of demand is an economic concept that measures the

responsiveness in the quantity demanded of one good when the price for another good
changes.
• The cross elasticity of demand for substitute goods is always positive because the
demand for one good increases when the price for the substitute good increases.
• Alternatively, the cross elasticity of demand for complementary goods is negative.

Topic 14 Advertising Elasticity of Demand

Advertising elasticity of demand (AED) is a measure of a market’s sensitivity to
increases or decreases in advertising saturation. Advertising elasticity is a measure of
an advertising campaign’s effectiveness in generating new sales. It is calculated by
dividing the percentage change in the quantity demanded by the percentage change in
advertising expenditures. A positive advertising elasticity indicates that an increase in
advertising leads to an increase in demand for the advertised good or service.

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 The impact that an increase in advertising expenditures has on sales varies by industry.
Quality advertising will result in a shift in demand for a product or service. Advertising
elasticity of demand is valuable in that it quantifies the change in demand (expressed as
a percentage) by spending on advertising in a given sector. Simply put, how successful
a 1% rise in advertising spend is on raising sales in a specific sector when all other
factors are the same.

For example, a commercial for a fairly inexpensive good, such as a hamburger, may
result in a quick bump in sales. On the other hand, advertising a piece of jewelry may
not see a payback for a period of time because the good is expensive and is less likely
to be purchased on a whim.

Because a number of outside factors, such as the state of the economy and consumer
tastes, may also result in a change in the quantity of a good demanded, the advertising
elasticity of demand is not the most accurate predictor of advertising’s effect on sales.
For example, in a sector where all competitors advertise at the same level, additional
advertising may not have a direct effect on sales. A good example of this is when a
specific beer company advertises their product, which compels a consumer to buy beer,
but not simply the specific brand they saw advertised. Beer has an industry-wide
elasticity of 0.0, which means that advertising has little influence on profits. That said,
AEDs can vary widely based on brand.

Advertising Elasticity of Demand Applied

The primary use for advertising elasticity of demand is making sure advertising
expenses are justified by their returns. A price comparison of AED and price elasticity of
demand (PED) can be used to calculate whether more advertising would maximize
profit. PED applied alongside AED can help determine what impact pricing changes
may have on demand. For maximum profit, a company’s advertising-to-sales ratio
should be equal to minus the ratio of the advertising and price elasticities of demand, or
A/PQ = -(Ea/Ep). If a company finds that their AED is high, or if their PED is low, they
should advertise heavily.
Limitations of the AED value
However, while the AED value may be very useful, a simple numerical interpretation of
the value may not be entirely appropriate for a number of reasons. These might include:

• The purpose of a lot of advertising may not be to directly boost demand, but to help with
building a brand image or brand loyalty – the AED value cannot show the effectiveness
of this strategy
• If dealing with a family of brands, it may be difficult to isolate the effect of the advertising
spending on a single product or service and this may distort the apparent effectiveness
of the expenditure
• It may be difficult to isolate the impact of advertising expenditure to a specific time
period – some campaigns are ongoing over a considerable period and other factors
may also influence demand over an extended period.

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Topic 15 Demand Forecasting: Need, Objectives and Methods
Some of the popular definitions of demand forecasting are as follows:

According to Evan J. Douglas, “Demand estimation (forecasting) may be defined as a

process of finding values for demand in future time periods.”

In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period based on proposed marketing plan and a set of particular
uncontrollable and competitive forces.”

Demand forecasting enables an organization to take various business decisions, such

as planning the production process, purchasing raw materials, managing funds, and
deciding the price of the product. An organization can forecast demand by making own
estimates called guess estimate or taking the help of specialized consultants or market
research agencies.
Need of Demand Forecasting
Demand plays a crucial role in the management of every business. It helps an
organization to reduce risks involved in business activities and make important business
decisions. Apart from this, demand forecasting provides an insight into the
organization’s capital investment and expansion decisions.

(i) Fulfilling objectives

Implies that every business unit starts with certain pre-decided objectives. Demand
forecasting helps in fulfilling these objectives. An organization estimates the current
demand for its products and services in the market and move forward to achieve the set
goals.

For example, an organization has set a target of selling 50, 000 units of its products. In
such a case, the organization would perform demand forecasting for its products. If the
demand for the organization’s products is low, the organization would take corrective
actions, so that the set objective can be achieved.

(ii) Preparing the budget

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced
at Rs. 10, would be 10, 00, 00 units. In such a case, the total expected revenue would
be 10* 100000 = Rs. 10, 00, 000. In this way, demand forecasting enables
organizations to prepare their budget.

(iii) Stabilizing employment and production

Helps an organization to control its production and recruitment activities. Producing

according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource

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 according to requirement. For example, if an organization expects a rise in the demand
for its products, it may opt for extra labor to fulfill the increased demand.

(iv) Expanding organizations

Implies that demand forecasting helps in deciding about the expansion of the business
of the organization. If the expected demand for products is higher, then the organization
may plan to expand further. On the other hand, if the demand for products is expected
to fall, the organization may cut down the investment in the business.

(v) Taking Management Decisions

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

(vi) Evaluating Performance

Helps in making corrections. For example, if the demand for an organization’s products
is less, it may take corrective actions and improve the level of demand by enhancing the
quality of its products or spending more on advertisements.

(vii) Helping Government

Enables the government to coordinate import and export activities and plan international
trade.
Objectives of short-term demand forecasting :

1. Production policy: Short-term demand forecasting is used to evolve a suitable

production policy which can avoid the problems of over production and short supply.
2. Expenditure pattern: It helps the firm in purchasing. Knowledge of near future
economic conditions help the firm in reducing costs of purchasing raw materials and
controlling inventory.
3. Sales policy: Demand forecasting helps the firm in evolving a suitable sales policy.
4. Price policy: Sales forecasting is useful in determining pricing policy. When the market
conditions are expected to be weak, the firm can avoid an increase in price and vice-
versa.
5. Sales targets, controls and incentives: Short term demand forecasting is used to set
sales targets and for establishing controls and incentives.
6. Financial requirements: It is useful in forecasting short term financial requirements.
Cash requirement depends on production and sales levels. Hence sales forecasts help
the firm to make arrangements for necessary funds well in advance.

Objectives of long term demand forecasting :

1. New unit or expansion: Long term demand forecasting helps in planning of a new unit
or expansion of an existing unit of a business organization.
2. Financial requirements: It is useful in long term financial planning. Long-term sales
forecast is necessary to estimate long term financial requirements.

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3. Man power planning: Long term demand forecasting enables the firm to make
arrangements for training and personnel development. Demand forecasting is also
useful to the Government in determining import and export policies.

Objectives Of Demand Forecasting In Business Economics is well recognized by the

business organizations who want to produce goods at optimum level. The objectives of
short-term demand forecasting are different from those of long term demand
forecasting.
Methods of Demand Forecasting
There is no easy or simple formula to forecast the demand. Proper judgment along with
the scientific formula is needed to correctly predict the future demand for a product or
service. Some methods of demand forecasting are discussed below:

1. Survey of Buyer’s Choice

When the demand needs to be forecasted in the short run, say a year, then the most
feasible method is to ask the customers directly that what are they intending to buy in
the forthcoming time period. Thus, under this method, the potential customers are
directly interviewed. This survey can be done in any of the following ways:

• Complete Enumeration Method: Under this method, nearly all the potential buyers are
asked about their future purchase plans.
• Sample Survey Method: Under this method, a sample of potential buyers is chosen
scientifically and only those chosen are interviewed.
• End-use Method: It is especially used for forecasting the demand of the inputs. Under
this method, the final users i.e. the consuming industries and other sectors are
identified. The desirable norms of consumption of the product are fixed, the targeted
output levels are estimated and these norms are applied to forecast the future demand
of the inputs.

Hence, it can be said that under this method the burden of demand forecasting is on the
buyer. However, the judgments of the buyers are not completely reliable and so the
seller should take decisions in the light of his judgment also.

The customer may misjudge their demands and may also change their decisions in the
future which in turn may mislead the survey. This method is suitable when goods are
supplied in bulk to industries but not in the case of household customers.

2. Collective Opinion Method

Under this method, the salesperson of a firm predicts the estimated future sales in their
region. The individual estimates are aggregated to calculate the total estimated future
sales. These estimates are reviewed in the light of factors like future changes in the
selling price, product designs, changes in competition, advertisement campaigns, the
purchasing power of the consumers, employment opportunities, population, etc.

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 The principle underlying this method is that as the salesmen are closest to the
consumers they are more likely to understand the changes in their needs and demands.
They can also easily find out the reasons behind the change in their tastes.

Therefore, a firm having good sales personnel can utilize their experience to predict the
demands. Hence, this method is also known as Salesforce opinion or Grassroots
approach method. However, this method depends on the personal opinions of the sales
personnel and is not purely scientific.

3. Barometric Method

This method is based on the past demands of the product and tries to project the past
into the future. The economic indicators are used to predict the future trends of the
business. Based on the future trends, the demand for the product is forecasted. An
index of economic indicators is formed. There are three types of economic indicators,
viz. leading indicators, lagging indicators, and coincidental indicators.

The leading indicators are those that move up or down ahead of some other series. The
lagging indicators are those that follow a change after some time lag. The coincidental
indicators are those that move up and down simultaneously with the level of economic
activities.

4. Market Experiment Method

Another one of the methods of demand forecasting is the market experiment method.
Under this method, the demand is forecasted by conducting market studies and
experiments on consumer behavior under actual but controlled, market conditions.

Certain determinants of demand that can be varied are changed and the experiments
are done keeping other factors constant. However, this method is very expensive and
time-consuming.

5. Expert Opinion Method

Usually, the market experts have explicit knowledge about the factors affecting the
demand. Their opinion can help in demand forecasting. The Delphi technique,
developed by Olaf Helmer is one such method.

Under this method, experts are given a series of carefully designed questionnaires and
are asked to forecast the demand. They are also required to give the suitable reasons.
The opinions are shared with the experts to arrive at a conclusion. This is a fast and
cheap technique.

6. Statistical Methods

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 The statistical method is one of the important methods of demand forecasting.
Statistical methods are scientific, reliable and free from biases. The major statistical
methods used for demand forecasting are:

• Trend Projection Method: This method is useful where the organization has sufficient
amount of accumulated past data of the sales. This date is arranged chronologically to
obtain a time series. Thus, the time series depicts the past trend and on the basis of it,
the future market trend can be predicted. It is assumed that the past trend will continue
in future. Thus, on the basis of the predicted future trend, the demand for a product or
service is forecasted.
• Regression Analysis: This method establishes a relationship between the dependent
variable and the independent variables. In our case, the quantity demanded is the
dependent variable and income, the price of goods, price of related goods, the price of
substitute goods, etc. are independent variables. The regression equation is derived
assuming the relationship to be linear. Regression Equation: Y = a + bX. Where Y is the
forecasted demand for a product or service.

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