MANAGERIAL ECONOMICS (MBA I Sem )- UNIT 1

By: Dr. Meenakshi Tyagi

MEANING OF ECONOMICS:
Economics is the social science that analyzes the production, distribution, and consumption of
goods and services.
• Economics can be defined as- “Economics is the social science which studies human
activities and how society maximizes the satisfaction with the promotion of welfare and
economic growth by efficient use of limited or scarce resources which have alternative
uses.”

Economists at different times have emphasized different aspects of economic activities, and have
arrived at different definitions of Economics. These definitions can be classified into four groups:
1. Wealth definitions,
2. Welfare definitions,
3. Scarcity definitions, and
4. Growth-centred definitions.
1. Wealth definitions: Adam Smith, considered to be the founding father of modern Economics,
defined Economics as the study of the nature and causes of nations’ wealth or simply as the study
of wealth.
The central point in Smith’s definition is wealth creation. Implicitly, Smith identified wealth with
welfare. He assumed that, the wealthier a nation becomes the happier are its citizens. Thus, it is
important to find out, how a nation can be wealthy. Economics is the subject that tells us how to
make a nation wealthy. Adam Smith’s definition is a wealth-centred definition of Economics.
Main Characteristics of Wealth Definitions-
1. Exaggerated emphasis on wealth: These wealth centered definitions gave too much importance
to the creation of wealth in an economy. The classical economists like Adam Smith, J.S. Mill, J.B.
Say, and others believed that economic prosperity of any nation depends only on the accumulation
of wealth.
2. Inquiry into the creation of wealth: These definitions show that Economics also deals with an
inquiry into the causes behind the creation of wealth. For example, wealth of a nation may be
increased through raising the level of production and export.
3. A study on the nature of wealth: These definitions have indicated that wealth of a nation
includes only material goods (e.g., different manufactured items). Non-material goods were not
included. Hence, non material goods like services of teachers, doctors, engineers,
etc., are not considered as ‘wealth’.

2. Welfare definitions: Alfred Marshall also stressed the importance of wealth. But he also
emphasised the role of the individual in the creation and the use of wealth. He wrote: “ Economics
is a study of man in the ordinary business of life. It enquires how he gets his income and how he
uses it. Thus, it is on the one side, the study of wealth and on the other and more important side,
a part of the study of man”. Marshall, therefore, stressed the supreme importance of man in the
economic system. Marshall’s definition is considered to be material-welfare centred definition of
Economics.
Features of Welfare Definitions
The main features of welfare-centred definitions are as follows:
1. Study of material requisites of well-being: These definitions indicate that Economics studies
only the material aspects of well-being. Thus, these definitions emphasise the materialistic aspects
of economic welfare.

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2. Concentrates on the ordinary business of life: These definitions show that Economics deals
with the study of man in the ordinary business of life. Thus, Economics enquires how an individual
gets his income and how he uses it.
3. A stress on the role of man: These definitions stressed on the role of man in the creation of
wealth or income.

3. Scarcity definitions: The next important definition of Economics was due to Prof. Lionel
Robbins. In his book ‘Essays on the Nature and Significance of the Economic Science’, published
in 1932, Robbins gave a definition which has become one of the most popular definitions of
Economics. According to
Robbins, “Economics is a science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses”. A long line of economists after Robbins,
including Scitovsky and Cassel agreed with this definition and carried on their analysis in line with
this definition. It is a scarcity-based definition of Economics.
Main Features of Scarcity Definition
The principal features of scarcity definitions are as follows:
1. Human wants are unlimited: The scarcity definition of Economics states that human wants are
unlimited. If one want is satisfied, another want crops up. Thus, different wants appear one after
another.
2. Limited means to satisfy human wants: Though wants are unlimited, yet the means for
satisfying these wants are limited. The resources needed to satisfy these wants are limited. For
example, the money income (per month) required for the satisfaction of wants of an individual is
limited. Any resource is considered as scarce if its supply is less than its demand.
3. Alternative uses of scarce resources: Same resource can be devoted to alternative lines of
production. Thus, same resource can be used for the satisfaction of different types of human wants.
For example, a piece of land can be used for either cultivation, or building a dwelling place or
building a factory shed, etc.
4. Efficient use of scarce resources: Since wants are unlimited, so these wants are to be ranked in
order of priorities. On the basis of such priorities, the scarce resources are to be used in an efficient
manner for the satisfaction of these wants.
5. Need for choice and optimisation: Since human wants are unlimited, so one has to choose
between the most urgent and less urgent wants. Hence, Economics is also called a science of
choice. So, scarce resources are to be used for the maximum satisfaction (i.e., optimisation) of the
most urgent human wants.

4. Growth-Oriented Definition
In relatively recent times, more comprehensive definitions of Economics have been offered.
Thus, Professor Samuelson writes, “Economics is the study of how people and society end up
choosing, with or without the use of money, to employ scarce productive resources that could
have alternative uses to produce various commodities over time and distributing them for
consumption, now or in the future, among various persons or groups in society. It analyses
costs and benefits of improving patterns of resource allocation”.
Features of the Modern Growth-Oriented Definition:
1. Growth-orientation: Economic growth is measured by the change in national output over time.
The definition says that, Economics is concerned with determining the pattern of employment of
scarce resources to produce commodities ‘over time’. Thus, the dynamic problems of production
have been brought within the purview of Economics.
2. Dynamic allocation of consumption: Similarly, under this definition, Economics is concerned
with the pattern of consumption, not only now but also in the future. Thus, the problem of dividing

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the use of income between present consumption and future consumption has been brought within
the orbit of Economics.
3. Distribution: The modern definition also concerns itself with the distribution of consumption
among various persons and groups in a society. Thus, while the problem of distribution is implicit
in the earlier definitions, the modern definition makes it explicit.
4. Improvement of resource allocation: The definition also says that, Economics analyses the
costs and benefits of improving the pattern of resource allocation. Improvement of resource
allocation and better distributive justice are synonymous with economic development.
• Thus, issues of development of a less developed economy have also been made subjects of
the study of Economics. To put it summarily, the modern definition of Economics is -
“Economics is the social science which studies human activities and how society maximizes
the satisfaction with the promotion of welfare and economic growth by efficient use of
limited or scarce resources which have alternative uses.”

Nature of Economics:

In order to answer this question, it is essential to know what science is and what art is.

Science refers to a systemized body of knowledge which collects facts and tries to make an
association between these facts which are useful for daily life and works on some laws and
principles and these rules and principles are universally applicable. The following are the
essentials of science –

• A systematic study of facts

• Certain rules and principles

• Rules and principles of science are based on cause and effects

• Rules and principles of science are universally applicable.

Art refers to that branch of knowledge which teaches how to do a particular act in a systematic
manner or in its best.

Economics as Science

Economics is a systematised body of knowledge in which economic facts are studied and analysed
in a systematic manner. Like any other science, the generalisations, theories or laws of economics
trace out a causal relationship between two or more phenomena. Similarly, in economics, the law of
demand tells us that other things remaining the same, a fall in price leads to extension in demand
and a rise in price to contraction in demand. Here rise or fall in price is the cause and, contraction
or extension is its effect. Hence economics is a science like any other science which has its own
theories and laws which establish a relation between cause and effect.

Economics is also a science because its laws possess universal validity such as the law of
diminishing returns, the law of diminishing marginal utility, the law of demand, Gresham’s law,
etc.

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ECONOMICS AS A POSITIVE SCIENCE:

A positive science may be defined as “a body of systematized knowledge concerning what is.”
Economics is positive science because it does concern with “what is tax rate, growth rate,
inflation rate etc.”

ECONOMICS AS A NORMATIVE SCIENCE:

Normative science studies “what ought to be.” As a normative science, economics is concerned
with the evaluation of economic events from the ethical viewpoint. For example it is concerned
with what should be the growth rate, tax rate, literacy rate, employment rate for the
development of the nation.

Economics as an Art:

• Helpful in the solution of economic problem

• Increasing importance of applied economics

• Economic aspect of problems

• Economics as an art does not weaken its scientific aspect

Thus economics is a science in its methodology and an art in its application.

MICROECONOMICS: Microeconomics is the study of the economic actions of individuals

and small groups of individuals. This includes the study of particular firms, particular
households, individual prices, wages, income, individual industries and particular commodities.

MACROECONOMICS: Macroeconomics is that branch of economic theory which deals with

the study of the economy in the aggregates with specific focus on unemployment, inflation,
unemployment, business cycles, growth, monetary and physical policies.

Definition:

In the words of Boulding. “Macroeconomics deals not with individual quantities such as, but
with aggregate of these quantities, not with individual income but with national income, not
with the individual output but with national output.”

In the words of Shapiro. “Macroeconomics deals with the functioning of the economy as a
whole.”

DISTINCTION BETWEEN MICROECONOMICS AND MACROECONOMICS

Microeconomics Macroeconomics

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1. It is that branch of economics which deals 1. It is that branch of economics which deals
with the economic decision-making of with aggregates and averages of the entire
individual economic agents such as the economy, e.g., aggregate output, national
producer, the consumer, etc. income, aggregate savings and investment,
2. It takes into account small components of etc.
the whole economy. 2. It takes into consideration the economy of
3. It deals with the process of price any country as a whole.
determination in case of individual products 3. It deals with general price-level in any
and factors of production. economy.
4. It is known as price theory (since it 4. It is also known as the income theory
explains the process of allocation of (since it explains the changing levels of
economic resources along alternative lines national income in any economy during any
of production on the basis of relative prices particular time period.)
of various goods and services.) 5. It is concerned with the optimisation of the
5. It is concerned with the optimisation growth process of the entire economy.
goals of individual consumers and producers 6. It studies the circular flow of income and
(e.g., individual consumers are utility- expenditure between different sectors of the
maximisers, while individual producers are economy (say, between the firm sector and
profitmaximisers.) the household sector.)
6. It studies the flow of economic resources 7. Macroeconomic theories help us in
or factors of production from any individual formulating appropriate policies for
owner of such resources to any individual controlling inflation (i.e., rising price-level),
user of these resources, etc. unemployment, etc.
7. Microeconomic theories help us in 8. It takes into account the aggregates over
formulating appropriate policies for resource heterogeneous or dissimilar products (say, the
allocation at the firm level. Gross Domestic Product of any country
8. It takes into account the aggregates over during any year.)
homogeneous or similar products (e.g., the
supply of steel in an economy.)

Managerial Economics

Managerial economics can be defined as the application of economic theory and methodology to
business decision-making practice. More specifically, managerial economics is the use of tools and
techniques of economic analysis to solve the problems of decision-making by the business firms
which aim at achieving certain objectives subject to some constraints.
According to McNair and Meriam, “managerial economics consists of the use of economic models
of thought to analyse business situations”.

Nature of Managerial Economics

Managerial economics has some special characteristics, and these characteristics indicate the
nature of managerial economics. Some of the important characteristic features of managerial
economics are noted below:
1. Both Science as a well as art: Managerial economics works on the basis of some theories and
principles and tells how to make the best utilization of available resources. Thus this is both
science as well art.
2. Normative science: Mainly Managerial economics is normative science. It explains what
should be done to achieve the target of a firm.
3. Managerial economics is microeconomic in nature: Since managerial economics deals with
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the economic problems of individual business firms in an economy, it is microeconomic in nature.

However, the firm works within a given macroeconomic environment.
4. Prescriptive in nature: Managerial economics actually prescribes the ways through which a
business firm can achieve its goal within its constraints. It prescribes the policies that should be
undertaken by any business firm for achieving its specific target. Hence, managerial economics is
not concerned with mere description of economic theories.
5. Pragmatic in its approach: Managerial economics is pragmatic in its approach because it
emphasises on the real-life problems faced by any business firm and their possible solutions, rather
than concentrating only on some abstract economic theories (which are based on restrictive
assumptions).
6. Emphasises on quantitative analysis: Managerial economics is mainly concerned with some of
the quantitative aspects of business decisions. Business decisions relating to
(i) output to be produced, (ii) inputs to be used, (iii) prices to be fixed, (iv) estimated cost and
revenue schedules, etc., are expressed in quantitative terms. Some of the qualitative aspects of
production such as efficiency of labour or the efficiency of factor inputs, are also estimated in
quantitative terms. For instance, average productivity of the workers can be estimated to reflect
their efficiency.
7. Multi-disciplinary subject: It is a multi-disciplinary subject, and draws not only on economics
but also on other subjects such as mathematics, statistics, accounting theory, etc. Business firms use
various techniques to forecast the demand pattern, estimate the economic viability of a project, etc.
Thus, analysis of the present business environment, and forward planning require not only the
knowledge of economic theory but also other related subjects like mathematics and statistics.
Hence, managerial economics takes into consideration all these aspects of analytical framework.

Scope and Applications or relevance in business decision of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science.
Even then the following fields may be said to generally fall under Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
1. Demand Analysis and Forecasting: A business firm is an economic organisation which is
engaged in transforming productive resources into goods that are to be sold in the market. A major
part of managerial decision making depends on accurate estimates of demand. A forecast of future
sales serves as a guide to management for preparing production schedules and employing
resources. It will help management to maintain or strengthen its market position and profit base.
Demand analysis also identifies a number of other factors influencing the demand for a product.
Demand analysis and forecasting occupies a strategic place in Managerial Economics.
2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are
cause variations in cost estimates and choose the cost-minimizing output level, taking also into
consideration the degree of uncertainty in production and cost calculations. Production processes
are under the charge of engineers but the business manager is supposed to carry out the production
function analysis in order to avoid wastages of materials and time. Sound pricing practices depend
much on cost control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial

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Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business
firm largely depends on the correctness of the price decisions taken by it. The important aspects
dealt with this area are: Price determination in various market forms, pricing methods, differential
pricing, product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is one
who can form more or less correct estimates of costs and revenues likely to accrue to the firm at
different levels of output. The more successful a manager is in reducing uncertainty, the higher are
the profits earned by him. In fact, profit-planning and profit measurement constitute the most
challenging area of Managerial Economics.
5. Capital management: The problems relating to firm’s capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital expenditure
because it involves a large sum and moreover the problems in disposing the capital assets off are so
complex that they require considerable time and labour. The main topics dealt with under capital
management are cost of capital, rate of return and selection of projects.

Fundamental principles of managerial economics

 There are six basic principles of managerial economics. They are:

1. The Incremental Concept

2. The Marginal Concept
3. The Concept of Time Perspective
4. The Opportunity Cost Concept
5. The Discounting Concept
6. The Equi-marginal Concept
7. . Risk and Uncertainty
1. The Incremental Concept:
The incremental concept is probably the most important concept in economics and is certainly the
most frequently used in Managerial Economics. The two major concepts in this analysis are
incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas
incremental revenue means change in total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
2. The Marginal Concept- Managerial economics, or applying economic principles to business
decision-making, is a relatively young field. It first emerged in the early 1900s as businesses began
to adopt scientific methods to solve problems and make decisions.
The marginal principle is one of the essential concepts in managerial economics. Marginal analysis
implies judging the impact of a unit change in one variable on the other.

Marginal generally refers to small changes.

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It states that businesses should make decisions by considering each option’s marginal benefits and
marginal costs. In other words, businesses should compare the additional benefits of an option to its
additional costs and choose the option that provides the most benefit for the least cost.

3. Concept of Time Perspective: It was Marshall who introduced time element in economic
theory. The time perspective concept states that the decision maker must give due consideration
both to the short run and long run effects of his decisions. He must give due emphasis to the various
time periods. The economic concepts of the long run and the short run have become part of
everyday language. Managerial economists are also concerned with the short run and long run
effects of decisions on revenues as well as costs.

4. The Opportunity Cost Concept:

In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its
significance. In Managerial Economics, the opportunity cost concept is useful in decision involving
a choice between different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one com-
modity, we have to forego the production of another commodity. We cannot have everything we
want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of
alternatives is involved when carrying out a decision requires using a resource that is limited in
supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by
pursuing one course of action rather than another.

5. Equi-Marginal Concept:
One of the widest known principles of economics is the equi-marginal principle. The principle
states that an input should be allocated so that value added by the last unit is the same in all cases.
This generalisation is popularly called the equi-marginal. An optimum allocation cannot be
achieved if the value of the marginal product is greater in one activity than in another. It would be,
therefore, profitable to shift labour from low marginal value activity to high marginal value
activity, thus increasing the total value of all products taken together.

If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in
activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B.
The optimum is reached when the values of the marginal product is equal to all activities. This can
be expressed symbolically as follows:

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product. L = Labour

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to the

6. Discounting Concept:
This concept is an extension of the concept of time perspective. Since future is unknown and
incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is
worth more than a rupee will be two years from now. The mathematical technique to adjust for the
time value of money and computing present value is called ‘discounting’. The concept of
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discounting is found most useful in managerial economics in decision problems pertaining to

investment planning or capital budgeting.

TYPES OF BUSINESS DECISIONS

 Price and Output Decision

 Demand Estimation

 Choice of Technique of Production

 Advertising Decision

 Long-run Production Decisions

 Investment Decision

UTILITY ANALYSIS

Meaning of Utility:
The term utility in economics is used to denote that quality in a commodity or service by virtue of
which our wants are satisfied. In other words, “ Wants satisfying capacity of goods or services is called
Utility.
Definitions:

According to Jevons, “Utility refers to abstract quality whereby an object serves our purpose.

In the words of Hibdon, “Utility is the quality of good to satisfy a want.”

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According to Mrs. Robinson, “Utility is the quality in commodities that makes

individuals wants to buy them.”

Characteristics/ Features of Utility

1. Utility is Relative: As a utility of a commodity never remains the same. It varies with time and
place. E.g. Cooler has utility in summer not during winter season. A. Depends on Place: The utility of
certain products depends on the place, where they are being used. For example, woolen clothes do not give
utility in the equator region whereas they give a lot of utility in cold region.
B. Depends on Time and Season: The products utility depends on time and season as well. For example,
electric light gives a lot of utility during night time but it decreases during the day time. Similarly, ice has
utility for the people during summer season and loses it during the winter season.

2. Utility is Subjective: As it deals with the mental satisfaction of a man. A thing may
have different utility to different persons. E.g. Liquor has utility for drunkard but for person
who is teetotaler, it has no utility.
3. Utility is independent of Morality: It has nothing to do with morality. Use of liquor may
not be proper from moral point of view, but as these intoxicants satisfy wants of
the drunkards, they have utility.
4. Depends on Knowledge: We can increase the utility by the advancement of knowledge. For example,
solar energy existed centuries ago but it gave a little utility. Now with the advancement of science and
technology its utility has increased many times.
5. Depends on Form: As a product, it also depends on its form and hence called form utility. Take the
case of wood. It does not have much utility in it. But if wood is changed into chair its utility will go up.
Similarly, there is not much utility in leather whereas it has a lot in the form of shoes.
6. Utility Depends on the Intensity of Want: Utility is the function of intensity of want. A want which
is unsatisfied and greatly intense will imply a high utility for the commodity concerned to a person. But
when a want is satisfied in the process of consumption it tends to experience a lesser utility of the
commodity than before. Such an experience is very common and it is described as a tendency of
diminishing utility experienced with an increase in consumption of a commodity. In other words, the
more of a thing we have, the less we want it.

APPROACHES OF UTILITY
1. CARDINAL UTILITY
Definition: 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. They have introduced a hypothetical unit called
as “Utils” meaning the units of utility.

The cardinal utility approach used in analyzing the consumer behavior depends on the following
assumptions.

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.
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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: 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.

Explanation

ORDINAL UTILITY

Ordinal Utility is propounded by the modern economists, J.R. Hicks, and R.G.D. Allen, which
states that it is not possible for consumers to express the satisfaction derived from a commodity in
absolute or numerical terms. Modern Economists hold that utility being a psychological
phenomenon, cannot be measured quantitatively, theoretically and conceptually. However, a person
can introspectively express whether a good or service provides more, less or equal satisfaction
when compared to one another.
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In this way, the measurement of utility is ordinal, i.e. qualitative, based on the ranking of
preferences for commodities. For example: Suppose a person prefers tea to coffee and coffee to
milk. Hence, he or she can tell subjectively, his/her preferences, i.e. tea > coffee > milk.

ASSUMPTIONS

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.

Example:
For example, a person has a limited amount of income which he wishes to spend on two
commodities, mangoes and oranges. Let us suppose that the following commodities are equally
valued by him:

Table: Indifference schedule

Combination Mangoes Oranges

A 1 14

B 2 9

C 3 6

D 4 4

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E 5 2.5

Figure: Graphical representation of indifference curve

Figure/Diagram of Indifference Curve:

The consumer’s preferences can be shown in a diagram with an indifference curve. The
indifference showing nothing about the absolute amounts of satisfaction obtained. It merely
indicates a set of consumption bundles that the consumer views as being equally satisfactory.

It may here be noted that while an indifference curve shows all those combinations of mangoes and
oranges which provide equal satisfaction to the consumer but it does not indicate exactly how much
satisfaction is derived by the consumer from these combinations. It is because of the fact that the
concept of ordinal utility does not involve the qualitative measurement of utility.
INDIFFERENCE CURVE

An indifference curve is a graph showing combination of two goods that give the consumer equal
satisfaction and utility.
Here are four basic properties of an indifference curve. These properties are
Indifference curve slopes downwards to right- An indifference curve can neither be horizontal
line nor an upward sloping curve. This is an important feature of an indifference curve. When a
consumer wants to have more of a commodity, he/she will have to give up some of the other
commodity, given that the consumer remains on the same level of utility at constant income. As a
result, the indifference curve slopes downward from left to right.

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By: Dr. Meenakshi Tyagi

In the above diagram, IC is an indifference curve, and A and B are two points which represent
combination of goods yielding same level of satisfaction. We can see that when X1 amount of
commodity X was consumed, Y1 amount of commodity Y was also consumed. When the consumer
increased the consumption of commodity X to X2, the amount of commodity Y fell to Y2. And,
thus the curve is sloping downward from left to right.

Indifference curve is convex to the origin- As mentioned previously, the concept of indifference
curve is based on the properties of diminishing marginal rate of substitution. According to
diminishing marginal rate of substitution, the rate of substitution of commodity X for Y decreases
more and more with each successive substitution of X for Y. Also, two goods can never perfectly
substitute each other. Therefore, the rate of decrease in a commodity cannot be equal to the rate of
increase in another commodity. Thus, indifference curve is always convex (neither concave nor
straight).

Indifference curve cannot touch any axis: Indifference curves cannot touch either the x-axis or
the y-axis because it would mean that the consumer is only interested in one commodity and has no
demand for the other.
Indifference curve cannot intersect each other- Each indifference curve is a representation of
particular level of satisfaction. The level of satisfaction of consumer for any given combination of
two commodities is same for a consumer throughout the curve. Thus, indifference curves cannot
intersect each other.

The following diagram will help you understand this property clearer.

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By: Dr. Meenakshi Tyagi

Higher indifference curve represents higher level of satisfaction- Higher the indifference
curves, higher will be the level of satisfaction. This means, any combination of two goods on the
higher curve give higher level of satisfaction to the consumer than the combination of goods on the
lower curve.

In the above figure, IC1 and IC2 are two indifference curves, and IC2 is higher than IC1. We can
also see that Q is a point on IC2 and S is a point on IC2. Combination at point Q contains more of
both the goods (X and Y) than that of the combination at point S. We know that total utility of
commodity tends to increase with increase in stock of the commodity. Thus, utility at point Q is
greater than utility at point S, i.e. satisfaction yielded from higher curve is greater than satisfaction
yielded from lower curve.

AN INDIFFERENCE MAP:

A graph showing a whole set of indifference curves is called an indifference map. An indifference
map, in other words, is comprised of a set of indifference curves. Each successive curve further
from the original curve indicates a higher level of total satisfaction.

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 MANAGERIAL ECONOMICS (MBA I Sem )- UNIT 1
By: Dr. Meenakshi Tyagi

DEMAND ANALYSIS

Meaning: In common usage, demand means a desire or a want but in economics, Desire, want and
demand are three different concepts.
1. Demand is an effective desire: a desire becomes an effective desire only when it is supported by
following three factors; -
1. Desire for a commodity and the availability of desired commodity
2. Ability to pay
3. Willingness to pay

Prof. Mill suggests- “Demand of a commodity is the quantity of it that a consumer is ready to purchase
at a given price.” Thus, demand can be defined as an effective desire of a commodity which is
expressed with reference to a particular time and a particular price.
• Demand is an effective desire for a commodity that buyers are willing to purchase at given
prices for a given period.
Determinants of Demand/Factors affecting Demand
1. Price of the commodity: The price of a commodity affects the demand of that commodity.
If price raises demand decreases and when price decreases, demand increases.
2. Change in people’s income: More the people earn the more they will spend and thus the
demand will rise. A fall in income will see a fall in demand.

3. Change in fashion and taste: Commodities or which the fashion is out are less in demand
as compared to commodities which are in fashion. In the same way, change in taste of
people affects the demand of a commodity.

4. Change in prices of Substitute goods: Substitute goods or services are those which can
replace the want of another good or service. For example margarine is a substitute for
butter. Thus a rise in butter prices will see a rise in demand for margarine and vice versa.

5. Change in price of Complementary goods: Complementary goods or services are

demanded along with other goods and services or jointly demanded with other goods or
services. Demand for cars is affected the change in price of petrol. Same way, demand for
DVD players will rise if the prices of DVDs’ fall.

6. Consumer’s Expectations: if consumer expects higher income in future, he spends more

at present and thereby the demand for the goods increase and opposite will be the case if he
expects lower income in future. Further, if the consumer expects future prices of the goods
to increase, he would rather like to buy the commodity now than later. This will increase the
demand for the commodity in present. Opposite holds when it is expected that prices in
future will come down.

7. Changes in population: An increase in population will result in a rise in demand and vice
versa.

8. Quality of Product: If quality of product is good, demand of the product will be more and
vice versa.

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9. Government Policy: Economic policy adopted by the government also influences the
demand for commodities. If the government imposes taxes on various commodities in the
form of sales tax, excise duties, octroi etc., the price of these commodities will increase. As
a result, the demand of such commodities is very likely to fall.
10. Advertisement: In this age of advertisement demand for many fashionable items are
created by advertising agents through T.V., newspapers, radios etc.
11. Credit policy: if government credit policy is liberal, it will increase the demand and vice
versa.

12. Interest Rates: If interest rates are low, demand will be high and vice versa.

The different types of demand –

1. Price Demand- shows relationship between price and quantity demanded. it shows
inverse relationship between price of commodity and quantity demanded.

2. Income demand- shows relationship between income and quantity demanded. In case
of normal goods demand curve is positive because if income increases demand for these
goods also increases and in case of inferior goods demand curve is negative if income
increases demand for these goods decreases.
3. Cross Demand- shows the relationship between quantity demanded and the price of
related goods. Goods are related in two ways: Substitute Goods and Complimentary
Goods. Substitute Goods are those goods which can be replaced by each other e.g. tea
and coffee, shirt and t-shirt. Complimentary Goods are those goods which are used
together e.g. petrol and car, ink and pen, shoes and socks. In case of substitute goods
demand curve will be positive and in case of complimentary goods demand curve will
be negative.

4. Direct and Derived Demand- Direct demand refers to demand for goods meant for
final consumption; it is the demand for consumers’ goods like food items, readymade
garments and houses. By contrast, derived demand refers to demand for goods which are
needed for further production; it is the demand for producers’ goods like industrial raw
materials, machine tools and equipments.

5. Demand for Consumer goods and Demand for Consumer goods- goods purchased
for consumption are known as Demand for Consumer goods i.e. demand for clothes;
milk, bread etc. and goods purchased for production purpose are known as Demand for
Capital goods i.e. demand for raw material, tools and machinery etc.

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6. Collective demand: demand for the products which have multiple uses. When price of
these product increases, people start to make the limited use of these products and when
price of these products decrease, people start multiple uses of them.

LAW OF DEMAND: The law of demand states that other factors being constant, price and
quantity demand of any good and service are inversely related to each other. When the price of a
product increases, the demand for the same product will fall and vice versa.

The above diagram shows the demand curve which is downward sloping. Clearly when the price of
the commodity increases from price p3 to p2, then its quantity demand comes down from Q3 to Q2
and then to Q3 and vice versa.

Assumptions of the law of demand: the law is based on the following assumptions-

1. There should be no change in the income of consumer.

2. No change in taste & preference of consumer.
3. No change in the prices of the related goods.
4. No change in the size of population.
5. Distribution of income & wealth should be equal.
6. The goods under question should be normal one.
7. There should be perfect competition in the market.

Reasons of Demand Curve Sloping Downward to the right:

1. Law of diminishing marginal utility: this law explains as consumer keep continue to
consume any product, the utility of that product decreases, he can purchase extra quantity at
lower price, and this is why demand curve is downward sloping.
2. Substitution effect: If consumers don't see a meaningful difference between products,
they'll buy the one with the lowest price, so a price increase will drive them toward
substitutes, while a reduction will draw them in.

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3. Income effect: When prices drop (or rise), people can buy more (or less) of a good for
the same amount of money because of increase (decrease) in real income

4. Change in number of consumers: when price of any commodity decreases, number of

consumers of that product increases because those who were not consuming in the past, now
they will also start to consume it because of lower price.

5. Diverse use of a commodity: some products have multiple uses. When price of these
product increases, people start to make the limited use of these products and when price of
these products decrease, people start multiple uses of them.

Exceptions to the Law of Demand

Basic Necessities or Highly Essential Good:

In case of basic naecessaties like salt, milk, sugar andcertain highly essential items such as life-
saving drugs, people buy a fixed quantity at all possible price. Heart patients will buy the same
quantity of ‘Sorbitrate’ whether price is high or low. Their response to price change is almost nil.

Possibility of Future Rise in Prices:

If a consumer anticipates that the price of a commodity will rise in future he will purchase more of
that commodity now. The consumer will purchase more even if current price is high.

Snob Appeal or Veblen Goods or prestigious goods:

People sometimes buy certain commodities like diamonds at high prices not due to their intrinsic
worth but for a different reason. The basic object is to display their riches to the other members of
the community to which they themselves belong. This is known as ‘snob appeal’, which induces
people to purchase items of conspicuous consumption. Such a commodity is also known as Veblen
good (named after the economist Thorstein Veblen) whose demand rises (fails) when its price rises
(falls).

Inferior goods/ Giffen goods:

Some special varieties of inferior goods are termed as giffen goods. Cheaper varieties of goods like
low priced rice, low priced bread, etc. are some examples of Giffen goods. Law of demand is not
applicable as the demand for such items.

Change in income
The demand for goods and services is also affected by change in income of the consumers. If the
consumers’ income increases, they will demand more goods or services even at a higher price. On
the other hand, they will demand less quantity of goods or services even at lower price if there is
decrease in their income. It is against the law of demand.

Movements along Demand Curve vs. Shift of Demand Curve

The basic difference between a move along a demand curve and a shifting in the curve is that the
former is caused by a change in price while the latter is not. A move along the curve results in a
different quantity demanded at a different price. A shifting in demand curve means that demand is
changing because of other factors. It means different quantity will be demanded at a given price
because due to change in income, family size, taste etc.
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Increase and decrease in demand represent shift of the demand curve to right or left resulting
from changes in factors such as income, tastes, prices of other goods etc whereas Expansion and
contraction represent movement upwards or downwards on the same curve resulting from a
change in price of the commodity.

Diagram-

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