MANAGERIAL

ECONOMICS
 Introduction

Managerial Economics as a course required for effective resource

management was put in place due to the following developments in the
global business environment:

(a) Growing complexity of business decision-making processes.

(b) Increasing need for the use of economic logic, concept, theories, and
tools of economic analysis in the process of decision-making.

(c) Rapid increases in the demand for professionally trained managerial

manpower.
 CHAPTER ONE
INTRODUCTION TO MANAGERIAL ECONOMICS

Contents
 Introduction

 Objectives

 Definition of Managerial Economics

 Importance of Managerial Economics

 Scope of Managerial Economics

 Managerial Economics and Gap between Theory and Practice

 Objectives

At the end of this chapter, you will be expected to:

1. Have an understanding of the meaning and
importance of managerial economics
2. Understand the relevant phases in business
decision making processes
3. Be familiar with the scope of Managerial
Economics
4. Be able to discuss freely how managerial
economics can fill the gap between theory and
practice
 Definition of Managerial Economics

• Managerial economics has been generally defined as the

study of economic theories, logic and tools of economic
analysis used in the process of business decision making. It
involves the understanding and use of economic theories
and techniques of economic analysis in analysing and solving
business problems.
• Economic principles contribute significantly towards the
performance of managerial duties as well as responsibilities.
Managers with some working knowledge of economics can
perform their functions more effectively and efficiently than
those without such knowledge.
 Cont’d
• Taking appropriate business decisions requires a good
understanding of the technical and environmental conditions
under which business decisions are taken. Application of
economic theories and logic to explain and analyse these
technical conditions and business environment can
contribute significantly to the rational decision-making
process.
 Nature of Managerial Economics

• Managerial Economics is both knowledge acquiring and knowledge

applying discipline

• managerial economics is science and arts

• Managerial economics is a Positive science

• Managerial economics is a Normative science

 Importance of Managerial Economics

• It helps the business executives to become much more responsive, realistic

and competent to face the ever changing challenges in the modern
business world.
• It helps in the optimum use of scarce resources of a firm to maximize its
profits.
• It also helps in achieving other objectives a firm like attaining industry
leadership, market share expansion and social responsibilities etc.
• It helps a firm in forecasting the most important economic variables like
demand, supply, cost, revenue, price, sales and profit etc and formulate
sound business polices
• It also helps in understanding the various external factors and forces which
affect the decision-making of a firm.
• It provides the necessary conceptual, technical skills, toolbox of analysis
and techniques of thinking and other such most modern tools and
 Economic Analysis and Business Decisions

Business decision-making basically involves the selection of best

out of alternative opportunities open to the business organization.
Decision making processes involve four main phases, including:
Phase One: Determining and defining the objective to be achieved.
Phase Two: Collection and analysis of information on economic,
social, political, and technological environment.
Phase Three: Inventing, developing and analyzing possible course
of action
Phase Four: Selecting a particular course of action from available
alternatives.
 Scope of Managerial Economics

Managerial economics comprises both micro- and macro-

economic theories. Generally, the scope of managerial economics
extends to those economic concepts, theories, and tools of
analysis used in analysing the business environment, and to find
solutions to practical business problems. In broad terms,
managerial economics is applied economics.
The areas of business issues to which economic theories can be
directly applied is divided into two broad categories:
1. Operational or internal issues; and,
2. Environment or external issues.
 Cont’d
Operational problems are of internal nature. These problems
include all those problems which arise within the business
organization and fall within the control of management. Some of
the basic internal issues include:
(a) choice of business and the nature of product (what to
produce); (b)choice of size of the firm (how much to produce);
(c) choice of technology (choosing the factor combination); (i)
choice of price (product pricing);
(d) how to promote sales;
(e) how to face price competition;
(f) how to decide on new investments;
 Cont’d
(g) how to manage profit and capital; and, (h) how to manage inventory.
The microeconomic theories dealing with most of these internal issues
include, among others:
The theory of demand, which explains the consumer behaviour in terms
of decisions on whether or not to buy a commodity and the quantity to be
purchased.
Theory of Production and production decisions. The theory of production
or theory of the firm explains the relationship between inputs and output.
Analysis of Market structure and Pricing theory. Price theory explains
how prices are determined under different market conditions.
Profit analysis and profit management. Profit making is the most
common business objective.
 Cont’d
However, making a satisfactory profit is not always guaranteed
due to business uncertainties. Profit theory guides firms in the
measurement and management of profits, in making
allowances for the risk premium, in calculating the pure return
on capital and pure profit, and for future profit planning.
Theory of capital and investment decisions. Capital is the
foundation of any business. It efficient allocation and
management is one of the most important tasks of the
managers, as well as the determinant of the firm’s success
level. Some of the important issues related to capital include:
choice of investment project; assessing the efficiency of
capital; and, the most efficient allocation of capital.
 Cont’d
Environmental issues are issues related to the general
business environment. These are issues related to the overall
economic, social, and political atmosphere of the country in
which the business is situated. The factors constituting
economic environment of a country include:
1. The existing economic system
2. General trends in production, income, employment, prices,
savings and investment, and so on.
3. Structure of the financial institutions.
4. Magnitude of and trends in foreign trade.
5. Trends in labour and capital markets.
 Cont’d
6. Government’s economic policies.
7. Social organizations, such as trade unions, consumers’ cooperatives,
and producer unions.
8. The political environment.
9. The degree of openness of the economy.
Managerial economics is particularly concerned with those
economic factors that form the business climate. In
macroeconomic terms, managerial economics focus on
business cycles, economic growth, and content and logic of
some relevant government activities and policies which form
the business environment.
 Managerial Economics and Gap between Theory and Practice

The Gap between Theory and Practice

It is a general knowledge that there exists a gap between theory

and practice in the world of economic thinking and behaviour. By
implication, a theory which appears logically sound might not be
directly applicable in practice. Take for instance, when there are
economies of scale. The theoretical conclusion of economies of
scale may not hold in practice.
 Cont’d
Economic theories are highly simplistic because they are
propounded on the basis of economic models based on
simplifying assumptions. Through economic models, economists
create a simplified world with its restrictive boundaries from
which they derive their conclusions. Although economic models
are said to be an extraction from the real world, the closeness of
this extraction depends on how realistic the assumptions of the
model are. It is a general belief that assumptions of economic
models are unrealistic in most cases. The most common
assumption of the economic models, as you may recall, is the
ceteris paribus assumptions (that is all other things being constant
or equal). This assumption has been alleged to be the most
unrealistic assumption.
 Cont’d
Though economic theories are, no doubt, hypothetical in nature,
in their abstract form however, they do look divorced from reality.
Abstract economic theories cannot be simply applied to real life
situations. This however, does not mean that economic models
and theories do not serve useful purposes. Microeconomic theory,
for example, facilitates the understanding of what would be a
complicated confusion of billions of facts by constructing
simplified models of behaviour that are sufficiently similar to the
actual phenomenon to be of help in understanding them. It
cannot, nevertheless, be denied the fact that there is a gap
between economic theory and practice. The gap arises from the
fact that there exists a gap between the abstract world of
economic models and the real world.
 Cont’d

It suffices to say that although economic theories do not directly

offer custom-made solutions to business problems, they provide a
framework for logical economic thinking and analysis. The need for
such a framework arises because the real economic world is too
complex to permit consideration of every bit of economic facts that
influence economic decisions. Economic analysis presents the
business decision makers with a road map; it guides them to their
destinations, and does not take them to their destinations.
 Cont’d
Managerial economics can bridge the gap between economic theory and
real world business decisions. The managerial economic logic and tools of
analysis guide business decision makers in:
1. identifying their problems in the achievement
2. collecting the relevant data and related facts;
3. processing and analysing the facts;
4. drawing the relevant conclusions;
5. determining and evaluating the alternative means of achieving the goal
6. taking a decision.
Without the application of economic logic and tools of analysis, business
decisions may likely be irrational and arbitrary. Irrationality is highly
counter-productive.
 Self Check

1. What does economic theory contribute to Managerial Economics?

2. List the important characteristics of Managerial Economics.

3. Summarize the scope of Managerial Economics as a learner.

4. Why should you study the Managerial Economics?

 CHAPTER TWO
OBJECTIVES OF BUSINESS
FIRMS
 Introduction
Business firms may have one or more of the following objectives:
1. Profit maximization
2. Maximisation of Sales revenue
3. Maximisation of the growth rate
4. Maximisation of manager’s utility function
5. Making satisfactory rate of profit
6. Long-run survival of the firm
7. Entry-prevention and risk-avoidance etc
In this chapter, we will discuss these business objectives with the aim of
acquainting you with the several reasons an entrepreneur will choose to be
in business.
 Profit Maximization
The conventional economic theory assumes that profit maximisation
is the only objective of business firms. Profit maximisation forms the
basis of conventional price theory. It is the most reasonable,
analytical, and productive business objective.
The term profit means different things to different people.
Businesspeople, accountants, tax collectors, employees, and
economists have their individual meaning of profit. In its general
sense, profit is regarded as income accruing to equity holders, in the
same sense as wages accrue to the workers; rent accrues to owners
of rentable assets; and, interest accrues to the money lenders.
 Cont’d

To the accountant, ‘profit’ means the excess of revenue over all paid
out costs, such as manufacturing and overhead expenses. It is more like
what is referred to a ‘net profit’. For practical purposes profit or
business income refers to profit in accounting sense. Economist’s
concept of profit is the pure profit or ‘economic profit’. Economic profit
is a return over and above the opportunity cost, that is, the income
expected from the second alternative investment or use of business
resources.
 Accounting profit Vs the Economic profit

The Accounting Profit

Accounting profit may be defined as follows: Accounting Profit = a = TR –
(w + r + I + m)
where TR = Total Revenue; w = wages and salaries; r = rent; i = interest;
and m = cost of materials.
You can observe that when calculating accounting profit, it is only the
explicit or book costs that are considered and subtracted from the total
revenue (TR).
 The Economic or Pure Profit

Unlike accounting profit, economic profit takes into account both the
explicit costs and implicit or imputed costs. The implicit or
opportunity cost can be defined as the payment that would be
necessary to draw forth the factors of production from their most
remunerative alternative use or employment. Opportunity cost is the
income foregone which the business could expect from the second
best alternative use of resources. The foregone incomes referred to
here include interest, salary, and rent, often called transfer costs.
 Cont’d
Economic profit also makes provision for (a) insurable risks (b) depreciation (c)
necessary minimum payment to shareholders to prevent them from
withdrawing their capital investments. Economic profit may therefore be
defined as residual left after all contractual costs, including the transfer costs of
management, insurable risks, depreciation, and payments to shareholders have
been met. Thus,
• Economic or Pure Profit= e = TR – EC – IC
• where EC = Explicit Costs; and, IC = Implicit Costs.
Note that economic profit as defined by the above equation may necessarily
not be positive. It may be negative since it may be difficult to decide
beforehand the best way of using the business resources. Pure profit is a short-
term phenomenon. It does not exist in the long-run under perfectly
competitive conditions.
 Example
Consider a manager who was earning $ 40,000 annually in XYZ company is about to
quit her job and instead to start her own business which she would manage. She is
planning to invest her $200,000 in a retail store business. The $200,000 money were
in bank which were earning a 5% interest annually. The projected income statement
for the year as prepared by an accountant is as shown below.
Sales $90,000
Cost of goods sold 40,000
Advertising expense 10,000
Depreciation expense 10,000
Utilities expense 3000
Property tax 2000
Miscellaneous expense 5000
Required: Accounting profit and Economic profit
Sales Revenue Maximisation as Business Objective

It was one famous economist, W. J. Baumol, who introduced the hypothesis of Sales
Revenue maximisation as an alternative to the profit-maximisation objective.
Baumol’s reason for the introduction of this hypothesis is the usual dichotomy
between business ownership and management, especially in large corporations. This
dichotomy, according to Baumol, gives managers some opportunity to set their
personal goals other than profit maximisation goal which business owners pursue.
Given the opportunity, managers would want to maximise their own utility function.
And, the most plausible factor in managers’ utility functions is the maximisation of
sales revenue. Baumol lists the factors that explain the managers’ pursuance of this
goal as follows:
 Cont’d
First, salary and other monetary benefits of managers tend to be more
closely related to sales revenue than to profits.
Second, banks and other financial institutions look at sales revenue while
financing business ventures.
Third, trend in sales revenue is a readily available indicator of a firm’s
performance.
Fourth, increasing sales revenue enhances manager’s prestige while profits
go to the business owners.
Fifth, managers find profit maximisation a difficult objective to fulfil
consistently over time and at the same level. Profits fluctuate with changing
economic conditions.
Finally, growing sales tend to strengthen competitive spirit of the firm in
the market, and vice versa.
 Technique of Total Revenue Maximisation

As noted earlier, total revenue (TR) can be defined by

TR = PQ

where P refers to unit price and Q refers to quantity sold.

The optimisation problem here is to find the value of Q that maximises total
revenue.

The rule for maximising total revenue is that total revenue will be maximized at the
level of sales (Q) for which marginal Revenu (MR) = 0. In other words, the revenue
from the sale of the marginal unit of the product must be equal to zero at the point
of maximum revenue.
 Cont’d

The marginal revenue (MR) is the first derivative of the total revenue
(TR) function. For example, we want to find the level of Q for which
revenue will be maximized if the price function is given by:
P = 500 – 5Q
TR = PQ = (500 – 5Q)Q
= 500Q – 5Q2
Marginal revenue (MR) = dTR/dQ = 500 – 10Q
500 – 10Q = 0
500 = 10Q
or, 10Q = 500
Q = 50.
 Cont’d

This indicates that the revenue-maximising level of output is 50 units.

The maximum total revenue can be obtained by substituting 50 for Q in

the total revenue function,

TR = 500Q – 5Q2

Thus, TR = 500(50) – 5(50)2

= 25,000 – 12,500

= 12,500.
 Technique of Output Maximisation: Minimisation of Average Cost

The optimum size of the firm is the size minimises the average cost of
production. This is also referred to as the most efficient size of the firm.
Knowledge of the optimum size of a firm is very important for future
planning under three important conditions:
First, a businessperson planning to set up a new production unit would
like to know the optimum size of the plant for future planning. This
issue arises because, as the theory of production indicates, the average
cost of production in most productive activities decreases to a certain
level of output and then begins to increase.
Second, the firms planning to expand their scale of production would
like to know the most efficient level of the economies of scale so that
they can be able to plan the marketing of the product accordingly.
 Cont’d
Third, businesspeople working under competitive business
environment are faced with a given market price. Their profit therefore,
depends on their ability to reduce their unit cost of production. And,
given the technology and input prices, the prospect of reducing unit
cost of production depends on the size of production. The problem
decision makers face under this condition is how to find the optimum
level of output or the level of output that minimises the average cost of
production.
As implied earlier, under general production conditions, the optimum
level of output is the one that minimises the average cost (AC), where
the average cost can be defined as the ratio between total cost (TC) and
quantity produced (Q). Thus,
AC = TC/Q
 Cont’d
Suppose the total cost function of a firm is given by:

TC = 100 + 60Q + 4Q2, then,

AC = TC/Q = (100+60Q+4Q2)/Q

= 100/Q + 60 + 4Q

The Minimisation Rule. Like the maximisation rule, the minimization rule is that the
derivative of the function to be minimised must be equal to zero. It follows that the
value the value of output (Q) that minimises average cost (AC) can be obtained by
taking the first derivative of the AC function and setting it equal to zero and solving for
Q.
 Cont’d
Thus, in the current example,
(dAC)/dQ = d(100Q-1+60+4Q)/dQ = (-100/Q2 + 4
-100/Q2 + 4 = 0
-100/Q2 = -4
-4Q2 = -100
Q2 = 100/4 = 25
Q = √25 = 5
Thus, the level of output that minimises average cost is 5 units.
 Maximisation of Firm’s Growth Rate as an Alternative Objective

According to Robin Marris, managers attempt to maximise a firm’s balanced

growth rate, subject to managerial and financial constraints. Marris defines
firm’s balanced growth rate (G) as:

G = GD = GC

where GD and GC are growth rate of demand for the firm’s product and
growth rate of capital supply to the firm, respectively.

Simply stated, a firm’s growth rate is said to be balanced when demand for its
product and supply of capital to the firm increase at the same rate.
 Cont’d
Marris translated these two growth rates into two utility functions: (i)
manager’s utility function (Um), and (ii) business owner’s utility
function (Uo), where:

Um = f(salary, power, job security, prestige, status).

Uo = f(output, capital, market-share, profit, public esteem).

 Maximisation of Managerial Utility Function as an Alternative Objective

O. E. Williamson propounded the hypothesis of maximisation of managerial

utility function. He argues that managers have the freedom to pursue
objectives other than profit maximisation. Managers seek to maximise their
own utility function subject to a minimum level of profit. According to
Williamson, manager’s utility function can be expressed as:
U = f(S, M, ID)
where S = additional expenditure on staff
M = managerial emoluments
ID = discretionary investments
According to the hypothesis, managers attempt to maximise their utility
function subject to a satisfactory profit. A minimum profit is necessary to
satisfy the shareholders or else the manager’s job security will be at stake.
 Long-run Survival and Market-share as a Business Objective

K. W. Rothschild proposed the hypothesis of long-run survival and market-share

goals. According to the hypothesis, the primary goal of the firm is long-run
survival. Other economists suggest that attainment and retention of a constant
market share is an additional objective of the firms. Managers therefore, seek to
secure their market share and long-run survival. The firms may seek to maximise
their long-run profit, which may not be certain.
Entry-prevention and Risk-avoidance as Business
Objective
Other alternative objectives of business firms as suggested by economists are the
prevention of entry of new firms and risk avoidance. It is argued that the motive
behind entry-prevention may be any or all of the followings:
(a) profit maximisation in the long-run; (b) securing a constant market share;
and, (c) avoidance of risk caused by unpredictable behaviour of new firms.
 CHAPTER THREE

THEORY OF PROFIT
 Introduction

Profit is the life blood of every business. Without profit no organization could
survive for a long period. It is regarded as an incentive for undertaking
entrepreneurial function. It is regarded as a reward for risk taking. It is the excess
of total revenue over total cost.

Thus, we can say, profit is the reward for entrepreneurial ability and goes to the
entrepreneur of the firm. According to Von Thunen, "profit is the residue after
deduction of interest, insurance for risk and wages for management." Thus, from
economic point of view, profit is residual of income over and above all economic
cost, both explicit and implicit, that results from the operation of a business. It is a
return to the entrepreneur for risk taking.
 Characteristics of Profit
1. Profit is the residual income.
2. Higher the risk, higher the profit
3. Profit is always uncertain and indeterminate.
4. Profit always bears dynamic fluctuation.
5. Profit may be positive, zero or negative.
6. Profit occurs by keeping total cost below total revenue.
7. It is the ability of entrepreneur i.e. able entrepreneur
will earn more profit.
 Types of Profit
Profit is the life blood of every business. The survival of any
firm or organization depends on the amount of profit. So,
profit is generally classified under the following heads:
1. Gross Profit
Gross profit or total profit is that residual income which
accrues to an entrepreneur when he excludes total explicit
cost from total revenue or total sales proceeds of the firm.
Explicit cost means visible cost of production, which includes
cost of raw material, wages, salary, power, etc. In other words,
it is the difference between total revenue and total explicit
cost. But in view point of financial accounting, gross profit is
the difference between total revenue and direct cost
 Cont’d
Gross Profit =Total revenue - Total cost Or Gross Profit = Total revenue -
Total Direct Cost
2. Net Profit \ Economic Profit
It is the reward paid to the entrepreneur for taking risk in the process of
production, bearing uncertainty, and reward for new innovations. In other
words, it is that residual income which accrues to the entrepreneur when
we deduct explicit and implicit cost from total revenue. Implicit cost is also
called invisible cost of production, which includes advertising cost, transport
cost, etc. Net Profit = Total Revenue - Explicit Cost - Implicit cost In terms of
accounting sense, when we deduct Direct and Indirect Cost from Total
Revenue, we arrive at Net Profit. Symbolically Net Profit = Total Revenue -
Direct cost - Indirect Cost
 Cont’d
3. Normal Profit
This concept was propounded by Alfred Marshal. It includes the production cost of
the representative firm. According to this concept, the firm Is able to recover cost
only. In other words, the firm is able to recover variable cost and not the fixed cost. So
it is said to be in normal profit situation or no profit no loss situation. It is the
minimum amount which an entrepreneur must get in order to survive in the market.
4. Super Normal Profit
Whatever income accrues over and above normal profit is called Super normal profit.
It accrues to the entrepreneur when he succeeds in keeping total cost below total
revenue. In other words, when average revenue is greater than average cost, the firm
incurs super normal profit or abnormal profit. But it will earn only normal profit in the
long run in case of monopolistic or imperfect competition. But in case of monopoly
market, the firm may even earn super normal or abnormal profit in the long run. it is
the amount which gives the firm motivation for expansion.
 Theories of Profit

The unsettled controversy on the sources of profit has led to the emergence of various
theories of profit in economics. The following discussions summarise the main theories.

1. Rent Theory of Profit

One of the widely known theories of profit was stated by F. A. Walker who theorised ‘profit’
as the rent of “exceptional abilities that an entrepreneur may possess” over others. He
believes that profit is the difference between the earnings of the least and the most
efficient entrepreneurs. Walker assumes a state of perfect competition, in which all firms
are presumed equal managerial ability. In Walker’s view, under perfectly competitive
conditions, there would be no pure or economic profit and all firms would earn only
marginal wages, which is popularly known in economics as ’normal profit’.
 Criticism

1. Profit does not always arises due to ability, other

factors (macro variables) are also responsible for
getting profit
2. Rent is generally positive and in some cases it
may be even zero, while Profit may be positive, zero,
and even negative.
3. Marginal entrepreneur does not exist in real world
4. Profit arises in a dynamic economy, where
changes take place continuously and not in a static
economy.
5. This is a short period theory where profit enters
into price, which is not possible in the long period
 2. Wage Theory of Profit

This theory was given by American Economist Taussig which is well

supported by Davenport. According to this theory, profit is similar to
wage, which is given to the entrepreneur for the services rendered by
him in the business. This theory explains the similarity between labour
and entrepreneur. Just as labour get wages for the services rendered in
the business, an entrepreneur gets profit in the business for providing
services in the business. Thus this theory give emphasis that profit is a
type of wage for the entrepreneur.
 Cont’d

But this theory has ignored the fact that a labour does not
undertake any risk whereas, an entrepreneur always undertakes
risk so he is liable to have profit. This theory also ignores that a
labour will always get wages under all circumstances i.e. wages
are always positive but this is not applicable in case of profit.
Because profit may be positive, zero, or negative.
 Criticism

1. Wages are always positive, but it is not essential that profit is always
positive. It may be positive, zero, or even negative in dimension
2. Labour and entrepreneur are not similar. Labour is generally
performing physical task whereas, entrepreneur is undertaking mental
exercise.
3. This theory does not explain the profit which is received by the
shareholder, who is not rendering any service.
4. Labour does not undertakes any risk, but an entrepreneur
undertakes risk so there is no similarity between labour and
entrepreneur
 3. Risk Theory of Profit

This theory was propounded by American economist Hawley in 1907.

According to this theory profit is the reward for risk taking. If any
entrepreneur in business undertakes risk, he is liable to have profit, and
if he is not prepared to take any risk, he is not liable to have profit.
Thus, this theory is based on the basic principle that higher the risk,
higher the profit and lower the risk, lower the profit.
 Criticism

1. There is no direct relationship between risk and profit

2. Profit does not arises due to risk taking rather accrues due to
avoidance of risk

3. Profit does not arise due to all types of risk.

4. It does not measure the volume of profit.

 4. Uncertainty Bearing Theory of Profit

This theory was propounded by American economist F. H. Knight in the year 1927.
According to this theory profit is the reward for bearing uncertainty. This theory is
also known as Knight's Theory of profit, as he lays down the difference that profit
does not arise from all types of risk. So he divided risk under two heads namely -
foreseen and unforeseen risk.

Foreseen risk is those which can be predicted and can be provided for through
insurance. It includes risk of fire, threat, etc. whereas unforeseen risk refers to those
which cannot be predicted and cannot be got covered through insurance. Under this
we include government policy, business cycles, competitive risk, technical risk, etc
 Cont’d

According to Prof Knight, profit does accrue from all types of risk. It arises due to non
– insurable risk. As this risk cannot be foreseen and no insurable company is ready to
cover these risks, these are called non-insurable risk or uncertainty bearing risk

Criticism

1. Uncertainty bearing is not any factor of production.

2. Profit is not the only reward for uncertainty bearing.

3. This theory does not measure the volume of profit.

4. This theory explains only sudden and causal explanation of profit.

 5. Dynamic Theory of Profit

This theory was propounded by American economist J.B. Clark.

According to him, profit always arises in a dynamic economy and not in
a static economy. The basic reason for arising profit in a dynamic
economy is continuous changes in the economy. In case of a static
economy, there is no change in economy. The activities of the previous
year will be repeated in current year, as a result price will be equal to its
cost and there will be no profit.
 Cont’d

According to Clark, there are five changes, which are continuously taking place
in the dynamic economy and they are responsible to have profit. They area)

a) continuous change in population

b) continuous changes in techniques of production

c) continuous changes in supply of capital

d) continuous changes in structure of organization

e) continuous changes in human wants due to change in taste, preference, and

habit of the consumer
 Cont’d

In the view of Clark, only those entrepreneurs will survive and develop and get
profit who will adopt these changes in order to satisfy consumer needs. Those
entrepreneurs who do not accept these changes will not survive and will not get
any amount of profit.

Criticism

1. Not every change does not bring profit.

2. Static economy does not exist in the real world.

3. This theory does not give any importance to uncertainty bearing and risk taking

4. It does not measure the volume of profit

 6. Innovation Theory of Profit

This theory was given by American economist J.A.Schumpeter. This

theory is very much similar to Dynamic theory of Profit. But instead of
adopting the five changes, which are continuously taking place in the
economy, this theory stresses more on innovation. By innovation,
Schumpeter means adopting new techniques of production, as a result
of which production cost would tend to decline and it will lead to
increase in profit.
If a firm wants to increase the level of profit, it can do this by two ways-
a) it can either increase the price of the product or
b) try to reduce cost of production
 Cont’d

The first strategy is not appropriate, due to increase in competition in the

market. If the firm increases the price of the product, the other rival will
not increase the price, as a result, the demand will fall, which will further
reduce the profit margin.

The second way is much better way to increase the volume of profit. This
theory explains that profit accrues to the firm only because of innovations
and not due to any other reason.
 Criticism

1. This theory ignores risk factor of the entrepreneur.

2. Profit does not accrue due to innovations only.

3. This theory fails to measure volume of profit.

4. This theory relates to short period only.

 7. Marginal Productivity Theory of Profit

This theory explains that reward for each and every factor of
production can be decided by marginal productivity of that factor of
production. The theory assumes entrepreneurial ability is also factor of
production. According to this theory, the value of entrepreneurial
ability i.e. profit is decided by his marginal productivity. As marginal
productivity curve for a factor of production is demand curve for that
factor, in the same manner marginal productivity curve is demand
curve for entrepreneur.
 Cont’d
The supply of entrepreneurial ability is scarce, and it depends on how much they
earn in an industry or his income i.e. transfer income and opportunity cost. It
cannot be increased or decreased easily and at once. Able entrepreneur's demand
is more and earns high profit and vice versa. Supply being scarce, entrepreneurs
earn huge profit due to higher marginal productivity.

Under conditions of perfect competition, profits of an entrepreneur tend to equal

to his marginal productivity. But when we analysis this theory we find that perfect
competition is no where found in the real world. Perfect competition is a myth.
 Criticism

1. This theory assumes all entrepreneur of same type with equal skill is wrong

2. This theory is one sided. It gives much emphasis on demand side and
ignores supply side.

3. This theory is based on assumption of perfect competition and in real

practices Perfect competition does not exist

4. This theory does not consider windfall profit

5 It is difficult to determine marginal productivity of entrepreneur because in

case but in case of a there is only one entrepreneur.
 8. Socialist Theory of Profit

This theory was propounded by American economist Karl Marx. According to this
theory, the value of a product is determined by labour itself involved in the process
of production. Under capitalist economy, major part of total produce is grabbed by
capitalist themselves and merely small portion of produce is given away to the
labour. Marx called that major portion which is taken away by capitalist as "surplus
value".

Thus, according to this theory, the main reason for accruing profit is exploitation of
labour by capitalist or is termed as "legalized robbery", as major part of produce is
grabbed by capitalist themselves.
 Cont’d
This will result into division of economy into two parts - Haves and Have not's. The
first category
enjoys at the cost of second. But the second category will struggle due to exploitation
and will go for strikes and lockouts. They will demand higher wages and other
amenities of life. Therefore, in the long run profit will tends to fall.
Criticism
1. This theory explains that labour is the sole factor which is responsible for accruing
profit, which is wrong. There are several other factors which are engaged in tempo of
production, including labour.
2. Profit is not the outcome of exploitation of labour, rather it is due to the ability of
the entrepreneur.
3. This theory ignores the risk taking and uncertainty bearing.
4. This theory does not take into consideration the concept of windfall profit.
5. This theory does not provide any means to measure the volume of profit.
 Monopoly Profit

Observe that the profit theories presented above were propounded in

the background of the existence of perfect competition. But as
conceived in the theoretical models, perfect competition is either non-
existent or is a rare phenomenon. An extreme opposite of perfect
competition is the existence of monopoly in the market. The term
monopoly characterises a market situation in which there is a single
seller of a commodity that does not have close substitutes.
Monopoly arises due to such factors as: (i) economies of scale;
(ii) sole ownership; (iii) legal sanction and protection; and, (iv) mergers
and acquisition.
 Cont’d

A monopolist can earn pure or ‘monopoly’ profit and maintain it in the

long run by using its monopoly powers, including:
(i) powers to control price and supply;
(ii) powers to prevent entry of competitors by price cutting; and,
(iii) monopoly power in certain input markets.
 Profit Policy
Profit is the necessity for survival, and for growth. Different firms adopt
different policy to achieve their organizational goals. Generally the firm
adopts two types of policies. The detail description of their policies are
given hereunder
1. Profit Maximization Policy
According to this policy, the main aim of every firm is to maximize their
profit. Profit is the only reward to measure efficiency of the firm,
according to the viewpoint of the policy. In other words, a firm is said
ideal, only if they maximize profit.
Firm needs funds for the purpose of expansion, which they can borrow
from internal source or from external source, through issue of shares
and debentures or through some other source. The lender will get
either interest or dividend as profit for the use of capital.
 Criticism

1. This is a vague policy because it does not show the clear picture. This
theory does not explain how a firm or organization can maximize its
level of profit.

2. This theory ignores risk and uncertainty factor, which is a essential

for every business organization to take into consideration.

3. This theory also ignores time factor. It does not explain in how much
time profit can be increased.
 2. Fair profit policy

Nowadays, firms are adopting Satisfactory profit policy, which further motivates
the firm to remain in a business for a longer period. This policy explains a
reasonable level of profit, which will enable the firm to clear all its liabilities and
a reasonable amount left will encourage them to stay in business. The firm
generally adopts this policy for the following reasons -

1. It enables the firm to stay alive in business for a longer period.

2. In case if a firm earns supernormal profit, it will attract the firms to enter into
market. So in order to reduce level of competition, they may adopt this policy.
 Cont’d

3. If the firms higher profit, it will encourage the labours to demand for higher
wages.

4. The firm also fix nominal price and earns fair profit in order to fulfil social
obligation.

5. The firms may follow fair price policy, if they are satisfied with the current
market price and from the volume of profit.

So by keeping these objectives in mind, the firm or organization may pursue the
fair profit policy. This policy is also advantageous from the view point of society.
 Self Assessment

1 Discuss the types of Profit

2 Define Profit. Give its essential features.
3 Critically explain rent theory of Profit.
4 Critically evaluate Marginal Productivity theory of Profit
5 Write Short Notes on-
(a) Uncertainty bearing theory of profit
(b) Socialist theory of profit
6 Define profit policy. Which is the appropriate policy, explain with
reason.
7 Briefly explain the theory given by prof. Clark.
8 Critically evaluate Innovation theory of profit.
 CHAPTER FOUR

OPTIMIZATION TECHNIQUES
 Introduction
The ability to make decisions that will lead to the best outcome under a given
set of circumstances is the distinguishing characteristics of a good manager.
Finding the best solution involves applying the fundamental principles of the
theory of optimization.

Firms choose input bundles to minimize the cost of producing any given output;
an analysis of the problem of minimizing the cost of achieving a certain payoff
greatly facilitates the study of a payoff-maximizing consumer. So, tools for
solving maximization and minimization problems are collectively known as
optimization problems.
 Cont’d
There are two ways of examining optimization.
• Maximization (example: maximize profit)
• In this case you are looking for the highest point on the
function.
• Minimization (example: minimize cost)
• In this case you are looking for the lowest point on the
function.

Maximization f(x) is equivalent to minimization –f(x)

 Types of Optimization Techniques
1). Constrained Optimization:

constrained optimization (in some contexts called constraint optimization) is the process of optimizing an objective function with

respect to some variables in the presence of constraints on those variables. The objective function is either a cost function or

energy function which is to be minimized, or a reward function or utility function, which is to be maximized. Constraints can be

either hard constraints which set conditions for the variables that are required to be satisfied, or soft constraints which have some

variable values that are penalized in the objective function if, and based on the extent that, the conditions on the variables are not

satisfied.

;
 Cont’d

Constraints have two basic types

— Equality Constraints -- some factors have to equal constraints

— Inequality Constraints -- some factors have to be less than or greater

than the constraints (these are upper and lower bounds)
 2). Unconstrained Optimization

An unconstrained optimization problem is one where you only

have to be concerned with the objective function you are
trying to optimize.
• An objective function is a function that you are trying to
optimize.
• None of the variables in the objective function are
constrained.
 Cont’d

Generally optimization is done in one of the following three common

ways:
• Calculus mathematics

• Linear programming

• Isocost and Isoqaunt analysis

Whatever used in the optimization process the basic thing is obtaining

maximum for revenue, profit and output and on the contrary minimum
for cost, time, wastage and others.
 Application of Differential Calculus to Optimization Techniques

This part introduces some of the basic techniques of calculus and its
application to economic problems. We shall be concerned here with
what is known as the ‘differential calculus. Differentiation is a method
used to find the slope of a function at any point. Although this is a
useful tool in itself, it also forms the basis for some very powerful
techniques for solving optimization problems.
 Example
1). What is the slope of the function y = 4x2 when x is 8?
Solution: Slope = dy/dx = 2 × 4x2−1 = 8x When x = 8, then slope = 8(8) = 64.
2). Find a formula that gives the slope of the function y = 6x3 for any value of
x.
Solution: Slope = dy/dx = 3 × 6x3−1 = 18x2 for any value of x.
3). What is the slope of the function y = 45x4 when x = 10?
Solution: Slope = dy/dx= 180x3, When x = 10, then slope = 180(1,000) =
180,000.
4). Differentiate the function y = 3x2 + 10x3 − 0.2x4.
5). Differentiate the function y = 6x + 2x2.
 First and second -order conditions for a maximum and minimum

Example
1). Derive the MR function for the non-linear demand schedule p = 80 −
q0.5.
Solution: TR = pq = q (80 − q0.5) = TR = 80q − q1.5
MR = dTR/dq = 80 − 1.5q0.5
In this non-linear case the intercept on the price axis is still 80 but the
slope of MR is 1.5 times the slope of the demand function.
2). For the total revenue function TR = 500q − 2q2, Find the value of MR
when q = 80 using calculus.
Solution: MR = dTR/dq = 500 − 4q. Thus when q = 80
MR = 500 − 4(80) = 500 − 320 = 180
 Cont’d
3). Show that the function y = 60x −0.2x2 satisfies the second-order
condition for a maximum when x = 150.
Solution: The slope of this function will be zero at a stationary point.
Therefore Dy/dx = 60 − 0.4x = 0 (1)
x = 150
Therefore the first-order condition for a maximum is met when x is 150.
To get the rate of change of the slope we differentiate (1) with respect
to x again, giving
d2y/dx2 = −0.4
This second-order derivative will always be negative, whatever the
value of x. Therefore, the second-order condition for a maximum is met
and so y must be a maximum when x is 150.
 Cont’d
4). Find the minimum point of the average cost function AC = 25q−1 + 0.1q2
Solution: The slope of the AC function will be zero when
dAC/dq = −25q−2 + 0.2q = 0 (1)
0.2q = 25q−2 : q3 = 125 = q=5
The rate of change of the slope at this point is found by differentiating (1), giving the
second-order derivative d2AC/dq2
= 50q−3 + 0.2
= 50/ (125) + 0.2 when q = 5
= 0.4 + 0.2 = 0.6 > 0
Therefore the second-order condition for a minimum value of AC is satisfied when q is 5.
The actual value of AC at its minimum point is found by substituting this value for q into the
original AC function. Thus AC = 25q−1 +0.1q2 = 25/5 +0.1×25 = 5+2.5 = 7.5
 Cont’d
5). When will average variable cost be at its minimum value for the TC function.
TC = 40 + 82q − 6q2 + 0.2q3?
Solution: The theory of costs tells us that MC will cut the minimum point of
both the average cost (AC) and the average variable cost (AVC) functions. We
therefore need to derive the MC and AVC functions and find where they
intersect. It is obvious from this TC function that total fixed costs TFC = 40 and
total variable costs
TVC = 82q − 6q2 + 0.2q3. Therefore,
AVC = TVC/q = 82 − 6q + 0.2q2 and
MC = dTC/dq= 82 − 12q + 0.6q2
Setting MC = AVC
82 − 12q + 0.6q2 = 82 − 6q + 0.2q2
0.4q2 = 6q. q= 6/0.4 = 15 at the minimum point of AVC.
 Profit maximization

We are now ready to see how calculus can help a firm to maximize profits, as the
following examples illustrate. At this stage we shall just use the MC = MR rule for profit
maximization.

Example

A monopoly faces the demand schedule p = 460 − 2q and the cost schedule TC = 20 +
0.5q2. How much should it sell to maximize profit and what will this maximum profit be?

Solution: To find the output where MC = MR we first need to derive the MC and MR
functions. Given TC = 20 + 0.5q2 then MC = dTC/dq = q (1)

As TR = pq = (460 − 2q)q = 460q − 2q2 then MR = dTR/dq = 460 − 4q (2)

 Cont’d
To maximize profit MR = MC. Therefore;
460 − 4q = q
460 = 5q
92 = q
The actual maximum profit when the output is 92 will be
TR − TC = (460q − 2q2) − (20 + 0.5q2)
= 460q − 2q2 − 20 − 0.5q2
= 460q − 2.5q2 − 20
= 460(92) − 2.5(8,464) − 20
= 42,320 − 21,160 − 20 = 21,140
 Exercises

1). A firm faces the demand schedule p = 184 − 4q and the TC function

TC = q3 − 21q2 + 160q + 40 What output will maximize profit?

2). A monopoly faces the following TR and TC schedules: TR = 300q − 2q2: TC = 12q3
− 44q2 + 60q + 30. What output should it sell to maximize profit?

3). A firm faces the demand function p = 190 − 0.6q and the total cost function TC =
40 + 30q + 0.4q2

(a) What output will maximize profit?

(b) What output will maximize total revenue?

(c) What will the output be if the firm makes a profit of 4,760?
 Constrained Optimization

In managerial economics we often come across resource allocation problems that

involve the optimization of some variable subject to certain limitations. For example,
a firm may try to maximize output subject to a budget constraint for expenditure on
inputs, or it may wish to minimize costs subject to a specified output being
produced. This portion explains how problems involving the constrained
optimization of non-linear functions can be tackled, using partial differentiation.

We shall consider two methods:

• constrained optimization by substitution, and

• The Lagrange multiplier method.

 Cont’d
The Lagrange multiplier method can be used for most types of constrained optimization
problems. The substitution method is mainly suitable for problems where a function with only
two variables is maximized or minimized subject to one constraint. We shall consider this
simpler substitution method first.
i. Constrained optimization by substitution
Consider the example of a firm that wishes to maximize output Q = f (K, L), with a fixed budget
M for purchasing inputs K and L at set prices PK and PL. The firm needs to find the
combination of K and L that will allow it to reach firm faces the production function Q = 12K0.4
L0.4 and can buy the inputs K and L at prices per unit of $40 and $5 respectively. If it has a
budget of $800 what combination of K and L should it use in order to produce the maximum
possible output?
 Solution
The problem is to maximize the function Q = 12K0.4 L0.4 subject to the budget constraint
40K + 5L = 800--------- (1)
(It is assumed that each constraint ‘bites’; e.g. the entire budget is used in this example.)
The theory of the firm tells us that a firm is optimally allocating a fixed budget if the last $1
spent on each input adds the same amount to output, i.e. marginal product over price should be
equal for all inputs. This optimization condition can be written as
MPK/PK = MPL/PL----- (2)
The marginal products can be determined by partial differentiation:
MPK = ∂Q/∂K= 4.8K−0.6 L0.4 --------------- (3)
MPL = ∂Q/∂L = 4.8K0.4 L−0.6---------------- (4)
 Cont’d

Substituting (3) and (4) and the given prices for PK and PL into (2)
(4.8K−0.6 L0.4)/ (40) = (4.8K0.4 L−0.6)/ (5)
Dividing both sides by 4.8 and multiplying by 40 gives
K−0.6 L0.4 = 8K0.4 L−0.6
Multiplying both sides by K0.6L0.6 gives
L = 8K ------(5)
Substituting (5) for L into the budget constraint (1) gives
40K + 5(8K) = 800
40K + 40K = 800
80K = 800
Thus the optimal value of K is
K = 10 and, the optimal value of L is
L = 80
 II). The Lagrange multiplier: constrained maximization
with two variables

The firm is trying to maximize output Q = 12K0.4 L0.4 subject to the budget constraint 40K +5L
= 800. The first step is to rearrange the budget constraint so that zero appears on one side of
the equality sign. Therefore
0 = 800 − 40K − 5L (1)
We then write the ‘Lagrange equation’ or ‘Lagrangian’ in the form
G = (function to be optimized) + λ (constraint)
Where G is just the value of the Lagrangian function and λ is known as the ‘Lagrange
multiplier’. (Do not worry about where these terms come from or what their actual values are.
They are just introduced to help the analysis.
 Cont’d
In this problem the Lagrange function is thus
G = 12K0.4 L0.4 + λ (800 − 40K − 5L) (2)
Next, derive the partial derivatives of G with respect to K, L and λ and set them equal to zero,
i.e. find the stationary points of G that satisfy the first-order conditions for a maximum.
∂G/∂K= 4.8K−0.6 L0.4 − 40λ = 0 (3)
∂G/∂L= 4.8K0.4 L−0.6 − 5λ =0 (4)
∂G/∂λ= 800 − 40K − 5L = 0 (5)
You will note that (5) is the same as the budget constraint (1).We now have a set of three linear
simultaneous equations in three unknowns to solve for K and L. The Lagrange multiplier λ can
be eliminated as, from (3),
0.12K−0.6 L0.4 = λ and from (4)
 Cont’d
0.96K0.4 L−0.6 = λ
Therefore
0.12K−0.6 L0.4 = 0.96K0.4 L −0.6
Multiplying both sides by K0.6 L0.6,
0.12L = 0.96K
L = 8K (6)
Substituting (6) into (5),
800 − 40K − 5(8K) = 0
800 = 80K
10 = K
Substituting back into (5),
800 − 40(10) − 5L = 0
400 = 5L
80 = L
 CHAPTER FIVE
ANALYSIS OF DEMAND
 Meaning of demand

The term “demand” implies a “desire” backed by ability and willingness to pay.
Unless a person has an adequate purchasing power or resource and the
preparedness to spend his resource, his mere desire for a commodity would not be
considered as his demand. For example, desire without purchasing power and
willingness to pay do not affect the market, nor do they generate production
activity. A demand with three attributes-

• Desire to buy

• Willingness to pay and

• Ability to pay becomes effective demand.

 Cont’d

Only effective demand figure is important in economic analysis and decisions.

In economics sense, the term demand for a commodity (i.e. quantity
demanded) has always refers to “a price”, “a period of time”, and “a place”.
Any statement regarding the demand for a commodity without reference to
its price, time of purchase and place is of no practical use. For instance, to say
demand for TV sets is 50,000 carries no meaning for a businessman, nor it
has any use in other kinds of economic analysis.
 Cont’d

A Meaningful statement regarding the demand for a commodity should

therefore contain the information regarding,

• Quantity demanded

• Price of the commodity

• Period of demanded

• Place of demanded

E.g. to say that, Annual demand for TV set in Hosana at 2000birr is 50,000 is
a meaningful statement
 The law of demand

The law of demand states that the demand for a commodity increases
when its price decreases and falls when its price raises, other thing
remains constant. This is an empirical law, i.e., this law is based on
observed facts and can be verified with new data. As the low reveals,
there is an inverse relationship between the price and quantity
demanded. The law holds under the condition that “other things remain
constant”. “Other things” includes income, price of the substitute and
complements, taste and preferences of the consumer, etc.
 Types of demand

The demand for the various kinds of goods is generally classified on the
basis of the kind of the consumers of a product, suppliers of the
product, nature of the goods, duration of consumption of a commodity,
interdependence of demand ,period of demand and nature of use of
the goods( intermediate or final). We have discussed here some of the
major classifications of demand.
a). Individual and market demand

market demand curve is horizontal summation of individual demands.

 The Market Demand Equation

The market demand function can also be expressed mathematically. If the

primary determinants of demand are the price of the product, income,
consumer prefer­ences, and the prices of other goods and services and
advertisement, the demand equation can be written as

The coefficients indicate the change in quantity demanded of one-unit

changes in the associated variables.
 Example

The market demand for test

Max, a graduating senior, has accumulated an impressive file of tests during his
college career. But now he needs to sell his test collection to obtain money for his
impending marriage. Three wealthy friends express interest in buying some of the
tests. Max determines that their individual demand equations are as follows:
Q1 = 30.00 - 1.00P
Q2 = 22.50 - 0.75P
Q3 = 37.50 - 1.25P
Where the quantity subscripts denote each of the three friends and price is mea­
sured in dollars per test. What is the market demand equation for Max's tests, and
how many more tests can he sell for each one-dollar decrease in price? If he has a
file of 60 tests, what price should he charge to sell his entire collection?
 Solution
Market demand, Qm , is the sum of the individual demands. Thus

Qm = Q I + Q 2 + Q 3 = (30.00 - 1 .0 0 P ) + (22.50 - 0 .7 5 P ) + (37.50 - 1.25P)

Simplifying yields
Qd = 90.00 - 3 .0 0 P
Because P is measured in dollars, a one-dollar decrease in price will increase
quantity demanded by three tests. To sell the entire 60-test collection, the price must
be set such that Qm = 60. That is,
60 = 90 - 3 .0 0 P

Solving this equation gives P = $10.00. Substituting this price back into the
individual demand equations gives Q I = 20, Q 2 = 15, and Q 3 = 25.
 Cont’d

b). Demand for Firm's Product and Industry's Products

c). Autonomous and derived demand

d). Demand for Durable and Nondurable Goods

e). Short term and long term demand

 Self Assessment

1). Define what is the meaning of demand? Write a clear short note at
list half page.

2). explain the major difference between all types of demand discussed
before?

3). What it says the low of demand?

 Determinants of Market Demand

• Price of the product,

• Price of the related goods----substitutes, complements
• Level of consumers' income,
• Consumers' taste and preference,
• Advertisement of the product,
• Consumer's expectations about future price and supply position,
• Demonstration effect and 'band-wagon effect',
• Consumer-credit facility,
• Population of the country
• Distribution pattern of national income
 Price elasticity

It is known that higher prices do not always result in greater total revenue. A price
change can either increase or decrease total revenue, depending on the nature of
the demand function. The uncertainty involved in pricing decisions could be
reduced if managers had a method of measuring the probable effect of price
changes on total revenue. One such measure is price elasticity of demand, which is
defined as the percentage change in quantity demanded divided by the
percentage change in price. That is,

Notice that Ep is negative. Except in rare and unimportant cases, price elasticity is
always less than or equal to zero. The explanation is the law of demand.
 Point versus Arc Elasticity

There are two approaches to computing price elasticities. The choice

between the two depends on the available data and the intended use. Arc
elasticities are appropriate for analyzing the effect of discrete (i.e.,
measurable) changes in price. For example, a price increase from $1 to $2
could be evaluated by computing the arc elasticity. In actual practice, most
elasticity computations involve the arc method. The other choice is point
elasticity. This approach can be used to evaluate the effect of very small
price changes or to compute the price elasticity at a particular price. Point
elasticities are important in theoretical economics.
 ARC ELASTICITY

The percentage change in price is the change in price divided by price (i.e.,
P/P). Similarly, the percentage change in quantity demanded is the change
in quantity divided by quantity (i.e., Q/Q). The conventional approach used
to calculate arc elasticities is to use average values for price and quantity.
Thus arc price elasticity is defined as

Where P1 and Q1 are the initial price-quantity pair and P2 and Q2 are the
price-quantity values after the price change. Simplifying and rearranging
terms, this equation can be written as
 Example

Suppose the market demand for playing cards is given by the equation

Q = 6,000,000 - 1000, 000P

Where Q is the number of decks of cards demanded each year and p is

the price in dollars. For a price increase from $2 to $3 per deck, what is

the arc price elasticity?

 Solution
Using the market demand equation, the quantity demanded is
4,000,000 decks of cards at a price of $2. Similarly, it is determined that
the quantity demanded is 3,000,000 decks at a price of $3 per deck.
Note that in equation above
is just Q/ P. The market demand equation can be used to determine Q/
P. In that each $1 increase in price causes a 1,000,000 decrease in
quantity demanded, it is known that Q/ P = -1,000,000. Thus the arc
price elasticity is
This means that a one-percent increase in price will reduce quantity
demanded by 0.71 percent.
 POINT ELASTICITY
Now consider extremely small changes in price. For P approaching
zero, the term Q/ P can be written as dQ/dP, where dQ/dP is the
derivative of Q with respect to P. Basically, dQ/dP expresses the rate at
which Q is changing for very small changes in P. For a linear demand
equation, dQ/dP is constant. For example, in the demand equation Q =
B + P, the derivative dQ/dP is . Thus the rate of change for a small price
change is the same as for large changes. Hence for linear demand
equation, dQ/dP = Q/ P.
For small price changes, and are approximately equal. Thus either
price can be used in the calculation with no significant effect on the
computed price elasticity. Hence the equation for point elasticity can be
written as
 Example
T h is E q u a tio n is u se d to c a lc u la te p ric e e la stic itie s a t a p a rtic u la r p o in t o n th e
d e m a n d c u rv e .For example, consider the price-quantity data used earlier in this
section. It has already been determined that dQ /d P = -1 . If price is $6 and the quantity
demanded is 5 units, the price elasticity is
dQ P 6
EP   1   1.20
dP Q 5
That is, for very small price changes above or below $6, the percentage change in
quantity demanded is -1.20 times the percentage change in price. Again, the minus
sign denotes that there is an inverse relationship between price and quantity.
 Example 2
Point elasticities can also be computed from a demand equation. Suppose that the
demand equation is as follows:
QD = 100 - 4P
Because the relationship is linear, dQ/dP is constant and equal to the rate of change
in Q0 for each l-unit change in P. Note that quantity demanded changes by -4 units
for each unit increase in P. Thus dQ/dP = -4.
Suppose that P = $10. Substituting this value into the demand equation yields
Q D 60 . Thus the point elasticity at P = $10 is

10
E p  4   0.67
60
The interpretation is that 1 percent increases in price causes a 0.67 percent reduction
in quantity demanded.
 Price Elasticity and Marginal Revenue

It is useful to classify demand relationships on the basis of price elastici­

ties. The following classification scheme is frequently used:
Ep > 1 Elastic
Ep = 1 Unitary elastic
Ep < 1 Inelastic
 PRICE ELASTICITY AND DECISION MAKING

Information about price elasticities can be extremely useful to

managers as they contemplate pricing decisions. If demand is inelastic
at the current price, a price decrease will result in a decrease in total
revenue. Alternatively, reducing the price of a product with elastic
demand would cause revenue to increase. The effect on total revenue
would be the reverse for a price increase. However, if demand is unitary
elastic, price changes will not change total revenues. The relationship
between elasticity and total revenue can be Shown using simple
calculus. Total revenue is price times quantity.
 Cont’d
Taking the derivative of total revenue with respect to quantity yields marginal revenue:

(TR) ( PQ) P
MR   P 
Q Q Q
Equation above states that the additional revenue resulting from the sale of
one more unit of a good or service is equal to the selling price of the last unit
(P), adjusted for the reduced revenue from all other units sold at a lower price (Q
dP/dQ). This equation can be written
 Q P 
MR  P 1  
 P Q 
 Cont’d
But note that (Q /P ) P / Q = 1 E P , th u s

 1 
MR  P 1  
 EP 

The above Equation indicates that marginal revenue is a function of the elasticity of
demand. For example, if demand is unitary elastic E P  1 then

 1 
MR P 1   0
  1 

Because marginal revenue is zero, a price change would have no effect on total
revenue. In contrast, if demand is elastic, E p < - 1 and ( 1 + 1 / E p > 0. Hence,
marginal revenue is positive, which means that, by increasing quantity demanded, a
price reduction would increase total revenue.
 Cont’d

The Equation also implies that if demand is inelastic, marginal revenue is negative,
indicating that a price reduction would decrease total revenue.
Some analysts question the usefulness of elasticity estimates. They argue that
elasticities are redundant, in that the data necessary for their determination could be
used to determine total revenues directly. Thus managers could assess the effects of a
change in price without knowledge of price elasticity. Although this is true, elasticity
estimates are valuable, in that they provide a quick way of evaluating pricing policies.
For example, if demand is known to be elastic, it is also known that a price increase
will reduce total revenues.
 Income Elasticity

Income elasticities are used to measure the responsiveness of demand

to changes in income. When other factors are held constant, the
income elasticity of a good or service is the percentage change in
demand associated with a 1 percent change in income. As with price
elasticity, income elasticity can be expressed in either arc or point
terms. Arc income elasticity is used when relatively large changes in
income are being considered and is defined as
Where Q1 and I 1 represent the initial levels of demand and income, and Q2 and I 2 are
the values after a change in income.
 Example
suppose that the demand for automobiles as a function of income per capita is given by
the equation

Q 50000  5( I )

What is the income elasticity as per capita income increases from $10,000 to $11,000?
Substituting I 1 = $10,000 into the equation, quantity demanded is 100,000 cars.

Similarly, at I 2 = $11,000, quantity demanded is 105,000 automobiles. Thus

105,000  10,0000 11,000  10,000

EI   0.512
11,000  10,000 105,000  100,000

The interpretation of this result is that over the income range $ 1 0,000 to $11,000, each
1 percent increase in income causes about five-tenths of 1 percent increase in quantity
demanded.
 Cont’d
If the change in income is small or if income elasticity at a particular income level is
to be determined, a point elasticity is appropriate. In this case, Q I is expressed as
dQ/dJ. Thus

dQ I
EI 
dI Q

To illustrate, if Q = 50,000 + 5I as before, each one-unit increase in income is

associated with a five-unit increase in demand. Thus d Q /d 1 = 5. For 1= $10,500,
demand is 102,500 units and the income elasticity is

10,500
E I 5  0.512
102,500
N o te th a t th is v a lu e is id e n t ic a l to th e a rc e la s tic ity b e tw e e n $ 1 0 ,0 0 0 a n d $ 1 1 ,0 0 0
o f in c o m e . T h e y a re e q u a l b e c a u s e d e m a n d is a lin e a r fu n c tio n o f in c o m e .
 Inferior Goods, Necessities, and Luxuries

Income elasticities can be either negative or positive. When they are

negative, an increase in income is associated with a decrease in the
quantity demanded of the good or service. Goods with negative income
elasticities are defined as inferior goods.
N orm al goods and services have positive incom e elasticities. They can be
further classified by the m agnitude of E I , If 0 < E I  1, the percentage change in
dem and is positive but less than or equal to the percentage change in incom e.
Such goods and services are referred to as necessities. That is, dem and is
relatively unaffected by changes in incom e .
 Cont’d

Finally, luxuries are goods and services for w hich E I > 1. This m eans that the
change in dem and is proportionately greater than the chan ge in incom e. For
exam ple, if E I = 4, a 1 percent increase in incom e w ould cause a 4 percent increase
in dem and. Jewelry is an exam ple of a luxury good. A s individuals becom e
w ealthier, they have m ore disposable incom e. Thus purchases of necklaces, rings,
and fine w atches tend to represent a larger share of their incom es.
 Income Elasticity and Decision Making

The income elasticity for a firm's product is an important determinant of the firm's
success at different stages of the business cycle. During periods of expansion,
incomes are rising and firms selling luxury items such as gourmet foods and exotic
vacations will find that the demand for their products will increase at a rate faster
than the rate of income growth. However, during a recession, demand may decrease
rapidly. Conversely, sellers of necessities such as fuel and basic food items will not
benefit as much during periods of economic prosperity, but will also find that their
markets are somewhat recession-proof. That is, the change in demand will be less
than that in the economy in general. Knowledge of income elasticities can be useful
in targeting marketing efforts.
 Cross Elasticity

Demand is also demanded to changes in price of other goods is

measured influenced by prices of other goods and services. The respon­
siveness of quantity y cross elasticity, which is defined as the
percentage change in quantity demanded of one good caused by a 1
percent change in the price of some other good. That is,

W here x and y represent the go ods or services being co nsidered.

F or large chan ges in the price of y, arc cross elasticity is used . T he arc elasticity is
com puted as
Q x 2  Q x1 PY 2  PY 1
EC 
PY 2  PY 1 Q X 2  Q X 1
 Example
S uppose that dem and for x in term s of the price of Y is given by
Q X 100  0.5PY

If Py increases from $50 to $100, then, using the equation, it is determ ined that Q X

increases from 125 to 150 units. T hus the cross price elasticity is
150  125 100  50
EC   0.27
100  50 150  125
T he interpretation is that a 1 percent increases in the price of y C auses a 0.27
percent increase in the quantity dem anded of X .
 Cont’d
P oint cross elasticities are analog o us to the p oin t elasticities already d iscussed .
F or sm all chan ges in Py

dQ X Py
EC 
dPY Q X

B ased on the d em and equatio n Q X 100  0.5Py , the deriv ative, dQ X dPY = 0.5.

A t Py = $2 0, qu a ntity dem anded is 11 0 u n its. H en ce th e point cro ss elasticity is

20
EC 0.5  0.09
110
 Substitutes and complements

C ross elasticities are used to classify the relationship betw een goods. If EC > 0,
an increase in the price of y causes an increase in the quan tity dem anded of x, and
the tw o products are said to be substitutes. T hat is, o ne prod uct can be used in place
of (substituted for) the other. S uppose that the price of y increases. T his m eans
that th e opportunity co st of y in term s of x has increased. T he result is that
consum ers purchase less y and m ore of the relatively cheaper goo d x. B eef and
pork are exam ples of substitltes. A n increase in the price of beef usually increases
the dem and for pork, and vice versa.
 Cont’d

When, Ec < 0, the goods or services involved are classified as

complements (goods that are used together). Increases in the price of y
reduce the quantity demanded of that product. The 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.
 Cross Elasticity and Decision Making

M any large corporations produce several related products. G illette m akes both
razors and razor blades. F ord sells several com peting m akes of autom obiles.
W here a com pany's products are related, the pricing of one good can inf luence the
dem and for other products. G illette probably w ill sell m ore razor blades if it low ers
the price of its razors. In contrast, if the price of F ords is reduced, sales of M ercurys
m ay decline. Inform ation regarding cross elasticities can aid decisio n m akers in
assessing such im pacts.
C ross elasticities are also useful in establishing boundaries betw een industries.
 Cont’d
S o m e tim e s it is d iffic u lt to d e te rm in e w h ic h p ro d u c ts sh o u ld b e in c lu d e d in a n
in d u stry . F o r e x a m p le , sh o u ld th e m a n u fa c tu rin g o f c a rs a n d tru c k s b e c o n sid e re d
o n e in d u stry o r tw o ? O n e w a y o f a n sw e rin g su c h q u e stio n s is to sp e c ify in d u strie s
b a se d o n c ro ss e la stic itie s. T h is a p p ro a c h d e fin e s a n in d u stry a s in c lu d in g firm s
w h o se p ro d u c ts e x h ib it a h ig h p o sitiv e c ro ss e la stic ity . G o o d s a n d s e rv ic e s w ith
n e g a tiv e o r sm a ll c ro ss e la stic itie s a re c o n sid e re d to b e lo n g to d iffe re n t in d u strie s.
T h e d e fin itio n o f a n in d u stry m ig h t se e m to b e a n u n im p o rta n t m a tte r, b u t th e
c h o ic e c a n h a v e im p o rta n t im p lic a tio n s. F o r e x a m p le , th e o u tc o m e s o f a n titru st
c a se s a lle g in g ille g a l m o n o p o lie s a re so m e tim e s d e te rm in e d p rim a rily b y th e
in d u stry d e fin itio n u se d b y th e ju d g e s a ssig n e d to th e c a se
 Example
N a o d film p r o d u c tio n C o rp o ra tio n is a p u b lis h e r o f ro m a n c e n o v e ls - n o th in g
e x o tic o r e r o tic - ju s t s to r ie s o f c o m m o n p e o p le fa llin g in a n d o u t o f lo v e . T h e
c o rp o ra tio n h ire s a n e c o n o m is t to d e te rm in e th e d e m a n d f o r its p r o d u c t. A fte r
m o n th s o f h a rd w o r k a n d s u b m is s io n o f a n e x o rb ita n t b ill, th e a n a ly s t te lls th e
c o m p a n ie s th a t d e m a n d fo r th e firm 's n o v e ls Q X is g iv e n b y th e fo llo w in g
e q u a tio n :

Q X 12,000  5,000 PX  5 I  500 PC

W h e r e PX is th e p ric e c h a rg e d fo r th e R . J. S m ith n o v e ls , I is in c o m e p e r c a p ita ,

and PC is th e p ric e o f b o o k s fro m c o m p e tin g p u b lis h e rs .
Using this information, the company's managers want to
1. Determine what effect a price increase would have on total revenues.
2. Evaluate how sale of the novels would change during a period of rising incomes.
 Cont’d

1. 3. Assess the probable impact if competing publishers raise their prices.

Assume that the initial values of PX , I , andPC are $5, $10,000, and $6, respectively.
1. The effect of a price increase can be assessed by computing the point price elasticity
of demand. Substituting the initial values of I and PC yields

Q X 12,000  5(10,000)  500(6)  5,000 PX

Which is equivalent to:
Q P 65,000  5,000 PX
Note that d Q x ld P x = -5,000. At P x = $5, quantity demanded is 40,000 books. Using
these data, the point price elasticity is computed to be

5
E P  5,000   0.625
40,000
Because demand is inelastic, raising the price of the novels would increase total
revenue.
 Cont’d

2. The income elasticity determines whether a product is a necessity or a luxury.

It has already been determined that the initial quantity demanded at the given values
of the price and income variables is 40,000. From the demand equation the
derivative, dQ X dI = 5. Thus the income elasticity is

10,000
E I 5  1.25
40,000
Because E P > 1, the novels are a luxury good. Thus as incomes increase, sales should
increase more than proportionately.
3. The demand equation implies that dQ X dPC = 500. Thus it is known that Ec is
positive, meaning that Smith's romance novels and books from competing publishers
are viewed by consumers as substitutes. Computing Ec yields

6.00
E C 500  0.075
40,000
Hence, a 1 percent increase in the price of other books results in a 0.075 percent
increase in demand for R. J. Smith's romance novels.
 ADVERTISEMENT OR PROMOTIONAL ELASTICITY OF SALES

What is advertisement? How it determines demand of a certain commodity?

Good, expenditure on advertisement and on other sales-promotion activities
do help in promoting sales, but not in the same degree at all levels of the
total sales. The concept of advertisement elasticity is useful in determining
the optimum level of advertisement expenditure. The concept of
advertisement elasticity assumes a greater significance in deciding on
advertisement expenditure, particularly when government imposes
restriction on advertisement
S S cost or there is competitive advertising by the
S A
EA   
A A A S
rival firms. Advertisement elasticity
Where S = sales; (e) of
S is = increase sales
in sales; mayadvertisement
A= initial be definedcost, andas
A =
additional expenditure on advertisement.
 Cont’d
Interpretation of advertisement-elasticity.
Dear student! Like measure of other elasticities, the advertisement elasticity of sales
varies between E A = 0 and E A =  . Interpretation of some measures of advertising
elasticity is given below.
Elasticites Interpretation
E A 0 Sales do not respond to the advertisement expenditure.

E A >0 but <1 Increase in total sales is less than proportionate to the
increase in advertising expenditure
E A 1 Sales increases in proportion to the increase in expenditure
on advertisement
E A >1 sales increases at higher rate than the rate of increase of
advertisement expenditure.