Economy. The word economy comes from a Greek word for one who manages a household.

a household. Economics is the study of

how society manages its scarce (occasional) resources. Alfred Marshall: Economics is a study of man in the ordinary
business of life. It enquires how he gets his income & how he uses it. Thus, it is on the one side, the study of wealth & on the
other & more important side, a part of the study of man. According to Lionel Robbins, Economics is the science which
studies human behavior as a relationship between ends () & scarce means ( ) which have alternative
uses. Robbins describes the definition as not classificatory in "picking out certain kinds of behavior" but rather analytical in
"focusing attention on a particular aspect of behavior, the form imposed by the influence of scarcity."
Meaning of managerial economics. Managerial Economics refer to the integration of economy theory with business
practices. It deals with application of economy principles to the problem of business firm. It helps to solve real complex
problem of business firm. It is an application of the part of microeconomics that focuses on the topics that are of greatest
interest & importance to managers such as Risk, Demand, Production, Cost, Pricing, Market Structure & government
regulation. It helps rational decision making through model building. Haynes, Mote & Paul- Managerial economics refers to
those aspects of economics and its tools of analysis most relevant to the firms decision-making process. McGutgan &
Moyer- Managerial economics is the application of economic theory & methodology to decision-making problems faced by
both public & private institutions. Salvatore - Managerial economics refers to the application of economic theory & the
tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.
Importance of managerial economics: Business & industrial enterprises aim at earning maximum proceeds. To achieve this
objective, a managerial executive has to take recourse in decision-making which requires fair knowledge of the aspects of
economic theory & the tools of economic analysis which are directly involved in the process of decision-making. Since
managerial economics is concerned with such aspects & tools of analysis, it is pertinent to the decision-making process.
Spencer & Siegelman described the importance of managerial economics in a business & industrial enterprise as follows:
1. Accommodating traditional theoretical concepts to the actual business behavior & conditions.
2. Estimating economic relationships
3. Predicting relevant economic quantities
4. Understanding significant external forces
5. Basis of business policies
The Process of Model-building
The economics method illicit relationships with beautiful models
The steps: the hypothetical-deductive approach
i. make assumptions about behaviour
ii. work out the consequences of those assumptions
iii. make predictions
iv. test the predictions against the evidence
v. Predictions supported? The model is accepted as a good explanation (for the moment)
vi. Predictions refuted ? Go back and re-work the whole process




Definitions & assumptions
Theoretical analysis
Predictions
Predictions tested against data
If predictions not supported by data,
model is amended or discarded
If predictions borne out by data, the
model is valid, for the moment
Economic Laws




The Circular Flow of Economic Activity
o Assumption: The economy composed of households and firms only
o Households: A household is a person or a group of people that share their income.
o Firms: hire factors of production to produce goods and services for sale.
o Firms sell goods and services that they produce to households in markets for goods and services.
o Firms buy the resources they need to producefactors of productionin factor markets..


Fig: The Circular flow
The Circular Flow of Economic Activity. The flow of payments in an economy is a circular flow. The diagram represents the
transactions between firms & households in a simple economy.
In the upper loop, the arrow emanating from firms to households represents the sale by firms of goods & services to
households. On the other hand, the arrow from households to firms represents the payments.
In the lower loop, the arrow originating from the households to the firms shows that firms hire labor & capital from
households in order to produce goods & services. The arrow emanating from the firms indicates their payments for the
use of the factors of production.
Prices of outputs & inputs are determined in these markets & guide the decisions of all market participants,
The firm, an entity, organizes factors of production to produce goods and services,
The prices of product and factor of production guide interaction between individual & firms.
The scope of managerial economics includes following subjects:
1. Theory of demand
2. Theory of production
3. Theory of exchange or price theory
4. Theory of profit
5. Theory of capital and investment
6. Environmental issues
Idea
Hypothesis
Theory
Law
Check the idea, Prove it. If proved then
Prove the hypothesis. If proved then
Prove the theory. If proved then
Law is valid everywhere
The Production Possibilities Frontier Model
The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly
produce given the available factors of production and the available production technology.

Fig : The Production Possibilities Frontier
Theory of the Firm
A business enterprise represents a series of contractual relationships that
specify the rights & responsibilities of various parties. People directly involved
include customers, stockholders, management, employees & suppliers. Society is
also involved because businesses use scarce resources, pay taxes, provide
employment opportunities, & produce much of societys material and services
output. Firms are a useful device for producing and distributing goods & services.
They are economic entities & are best analyzed in the context of an economic model.

Expected Value Maximization. The model of business is called the theory of the rm. In its simplest version, the rm is
thought to have prot maximization as its primary goal. The rms owner-manager is assumed to be working to maximize
the rms short-run prots. Today, the emphasis on prots has been broadened to encompass uncertainty and the time
value of money. In this more complete model, the primary goal of the rm is long-term expected value maximization. The
value of the firm is the present value of the firms expected future net cash flows. If cash flows are equated to profits for
simplicity, the value of the firm today, or its present value, is the value of expected profits or cash flows, discounted back to
the present at an appropriate interest rate. This model can be expressed as follows:
Value of the Firm = Present Value of Expected Future Profits
1 2
1 2
1
...
(1 ) (1 ) (1 ) (1 )
n
n t
n t
t
i i i i
t t t t
=
= + + + =
+ + + +

Here,
1 2
, , ...
n
t t t represent expected profits in each year, t, and i is the appropriate interest or discount, rate. Because
profits (t ) are equal to total revenues (TR) minus total costs (TC), Equation 1.1 can be rewritten as
1
(1 )
n
t t
t
t
TR TC
Value
i
=

=
+

.
Managerial decisions should be analyzed in terms of their effects on value, as expressed in Equations 1.1 and 1.2.
Constraints and the Theory of the Firm
Resource constraints & Social constraints: Managerial decisions are often made in light of constraints imposed by
technology, resource scarcity, contractual obligations, laws, and regulations. Organizations frequently face limited
availability of essential inputs such as skilled labor, raw materials, energy, specialized machinery, & warehouse space.
Managers often face limitations on the amount of investment funds available for a particular project or activity. Decisions
can also be constrained by contractual requirements. Legal restrictions, which affect both production & marketing activities,
can also play an important role in managerial decisions. Laws which dene minimum wages, health & safety standards,
pollution emission standards, fuel efciency requirements & fair pricing & marketing practices all limit managerial exibility.
Limitations of the Theory of the Firm
Alternative theory adds perspective. Some of the more prominent alternatives are models in which size or growth
maximization is the assumed primary objective of management, models that argue that managers are most concerned
with their own personal utility or welfare maximization, and models that treat the firm as a collection of individuals with
widely divergent goals rather than as a single, identifiable unit. These alternative theories, or models, of managerial
behavior have added to our understanding of the firm. Still, none can supplant the basic value maximization model as a
foundation for analyzing managerial decisions.
Competition forces efficiency. Research shows that strong competition in markets for most goods and services typically
forces managers to seek value maximization in their operating decisions. Competition in the capital markets forces
managers to seek value maximization in their financing decisions as well.
Unfriendly takeovers are especially hostile to inefficient management that is replaced.
Profit Measurement. The free enterprise system would fail without profits & the profit motive. It plays a growing role in the
efficient allocation of economic resources worldwide.
Business versus Economic Profit : Business (accounting) profit reflects explicit costs and revenues. Business profit is the
Residual of sales revenue minus the explicit accounting costs of doing business. Economic profit is business profit minus the
implicit (noncash) costs of capital & other owner-provided inputs used by the firm. Profit above a risk-adjusted normal
return. Considers cash and noncash items.
Variability of Business Profits. Business profits vary widely. To better under-stand real-world differences in profit rates, it is
necessary to examine theories used to explain profit variations.
Frictional profit theory describes abnormal profits observed following unanticipated changes in product demand or cost
conditions. Monopoly profit theory asserts that above-normal profits are sometimes caused by barriers to entry that limit
competition. Innovation profit theory describes above-normal profits that arise as a result of successful invention or
modernization. Compensatory profit theory holds that above-normal rates of return can sometimes be seen as a reward to
firms that are extraordinarily successful in meeting customer needs, maintaining efficient operations, and so forth. Better,
faster, or cheaper than the competition is profitable.
Disequilibrium Profit Theories: i. Rapid growth in revenues. ii. Rapid decline in costs.
Role of Business in Society. Business contributes significantly to social welfare. Consumers benefit from an increasing
quantity and quality of goods and services available for consumption. Taxes on the business profits of firms, as well as on the
payments made to suppliers of labor, materials, capital, and other inputs, provide revenues needed to increase government
services. All of these contributions to social welfare stem from the efficiency of business in serving economic needs.
Why Firms Exist?
-Business is useful in satisfying consumer wants. In a free market economy, the economic system produces and allocates
goods and services according to the forces of demand and supply. Firms must determine what products customers want,
bid for necessary resources, and then offer products for sale.
- Firms exist by public consent to serve social needs. If social welfare could be measured, business firms might be expected
to operate in a manner that would maximize some index of social well-being.
Social Responsibility of Business
i. Serve customers ii. Provide employment opportunities iii. Obey laws and regulations.

Demand & Supply Market Equilibrium
Demand defined. A schedule or a curve that shows the various amounts of a product that consumers are willing &
able to purchase at each of a series of possible prices.
Law of demand. An inverse relationship exists between price and quantity demanded. As Price Falls Quantity Demanded
Rises & As Price RisesQuantity Demanded Falls
There are 3 reason why demand curve is downward sloping from left to right
(i) Income Effect
(ii) Substitution Effect
(iii) Diminishing Marginal Utility
Demand Curve, Individual Demand
Market Demand Curve relating the
quantity of a good that all consumers in a
market will buy to its price.
Income effect - if a product's price falls, the purchasing power of a consumer will increase, and therefore, there will be
greater quantity demanded at lower prices; the inverse (higher prices--->less quantity demanded) is also true.
Substitution effect - if the product price is lower, consumers will shift from purchasing a substitute (a similar product) to
buying more of this particular product, therefore, the quantity demanded is higher at lower prices.
Diminishing MU- the more additional units a consumer buys of a good, the less marginal utility they receive from it (they are
less happy with buying each new one). So to make them buy more of what they are already buying u have to lower the price.
Determinants of demand
Tastes
Number of Buyers
Income Normal (Superior& Inferior) Goods

Prices of Related Goods
Substitutes & Complements
Unrelated Goods
Expectations
Supply. Quantity supplied is the amount of a good that sellers are willing and able to sell.
Supply defined. Supply is a schedule or a curve showing the amounts of a product that producers are willing and able
to make available for sale at each of a series of possible prices.
Supply Schedule. is a table that shows the relationship between the price of the good and the quantity supplied.
Supply Curve A supply curve is a graph illustrating how much of a product a firm will supply at different prices.
Law of supply A direct relationship exists between price and quantity supplied. As Price Rises Quantity Supplied Rises and
As Price Falls Quantity Supplied Falls. The law of supply states that, other things equal, the quantity supplied of a good
rises when the price of the good rises. The law of supply states that there is a positive relationship between price and
quantity of a good supplied. This means that supply curves typically have a positive slope.
Factors or Determinants of Supply
1. The price of the good or service.
2. The cost of producing the good, which in turn depends on:
The price of required inputs (labor, capital, and land),
The technologies that can be used to produce the product,
3. The prices of related products.
Or,
( , , , , , )
S
x y input y
Q f P C C P T P =
[ 0, 0
x
Q Q
P C
o o
o o
> <

A Change in Supply vs a Change in Quantity Supplied.
Change in price of a good or service leads to change
in quantity supplied (movement along the curve)
Change in costs, input prices, technology, or prices
of related goods & services leads to change in
supply (shift in curve)

Individual & Market Supply Curve. Market supply curve is derived by adding the individual supply curves of each supplier.
From Individual Supply to Market Supply
The supply of a good or service can be defined for an individual firm, or for a group of firms that make up a market or an
industry.
Market supply is the sum of all the quantities of a good or service supplied per period by all the firms selling in the market
for that good or service.
Market Equilibrium The operation of the market depends on the interaction between buyers and sellers. An equilibrium is
the condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for
the market price to change. Only in equilibrium is quantity supplied equal to quantity demanded.
At any price level other than P0, the wishes of buyers and sellers do not coincide.
Market Disequilibria
Excess demand, or shortage, is the condition that exists when quantity demanded exceeds quantity supplied at the current
price. When quantity demanded exceeds quantity supplied, price tends to rise until equilibrium is restored.
Excess supply, or surplus, is the condition that exists when quantity supplied exceeds quantity demanded at the current
price. When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.
Price Ceiling A maximum price that sellers may charge for a good, usually set by government.
Slope is the changes in quantity demanded because of changes in any variable = Q/P
Elasticity is the percentage change in quantity demanded because of percentage change in any variable. Elasticity is a
measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.
Elasticity is of two types: (1) Point Elasticity and (b) Arc Elasticity.
Price Elasticity. The price elasticity of demand is the percentage change in quantity demanded divided by the percentage
change in price. Price Elasticity is the percentage change in quantity demanded because of percentage change in price.
Percentage change in quantity demanded % Q
. Types : 1. Point Price Elasticity 2. Arc Price Elasticity
Percentage change in price % P
D
c
A
= =
A


According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand
is always negative. Because it is always negative, economists usually state the value without the sign.
What Information Price Elasticity Provides. Price elasticity of demand & supply gives the exact quantity response to a
change in price. Elasticity:
When (In theory) When (In Absolute sense) The demand is called
1 c <
1 c >


Elastic if the %change in quantity is greater than the %change in price.
1 c = 1 c = Unitary Elastic
1 0 c < s 1 c < Inelastic

2 1
2 1 1
2 1
2 1
1
100
Q
,
100
Q Q
Q Q Q
slope Elasticity
P P
P P P
P

A
= = =

A


Price 10 9 8 7 6 5 4 3 2 1
Quantity 1 2 3 4 5 6 7 8 9 10
Point price elasticity Arc price elasticity
% 100
% 100
p
dQ dQ P dQ P
dP Q dP dP Q

= = =

2 1 1
2 1 1
3 2 9
4.5
8 9 2
Q Q P
P P Q

= = =


2 1 2 1
2 1 2 1
3 2 8 9
3.4
8 9 3 2
Q Q P P
P P Q Q
+ +
= = =
+ +

Income Elasticity is the percentage change in quantity demanded because of percentage change in income =
% Q
% Y
A
A

Point income elasticity Arc income elasticity
2 1 1
2 1 1
Y
Q Q Y dQ Y
dY Q Y Y Q

= =

2 1 2 1
2 1 2 1
Q Q Y Y
Y Y Q Q
+
=
+

Cross Elasticity is the % change in quantity demanded because of %change in the price of another good (say z). = % Q
%
Z
P
A
A

Point cross elasticity Arc cross elasticity
2 1 1
2 1 1
z Z
Z
Z Z Z
P Q Q P dQ
dP Q P P Q

= =

2 1 2 1
2 1 2 1
Z Z
Z Z
Q Q P P
P P Q Q
+
=
+


Elastic Inelastic
Positive Negative
Income
elasticity
Normal
When income increases, consumer prefers to buy
better goods rather than the INFERIOR goods. E.g.,
consumer prefers to buy soya bean oil in place of
palm oil when income increases. The palm oil is
called inferior good. When
, ,
X Z X
Y Q but Q Q | + | is inferior goods.
Bread, rice wheat etc.
Goods of basic
necessities. These would
be demanded whether
prices rise or fall.
Cross
elasticity
When prices of z good increases,
demand for x good increases.
Then x & z are substitutes.
When prices of z good increases, demand for x
goods declines. Then x & z are complementary.



Elastic Inelastic
Positive Negative
Price elasticity Exceptional ( ) Normal Normal (negative)
Income elasticity Normal Inferior (palm oil soyabean ) Basic Necessity Goods
Cross elasticity Substitute Complementary (Tennis racket ball )

Special Cases

The quantity changes enormously in
response to a proportional change in
price (E = ). The quantity does not
change at all in response to an
enormous proportional change in price
(E = 0).
Perfectly Inelastic Demand Curve

The demand curve is vertical, the
quantity demanded is totally
unresponsive to the price. Changes in
price have no effect on consumer
demand.
Perfectly Elastic Demand Curve

The demand curve is horizontal, any
change in price can and
will cause consumers to change their
consumption.



Elasticity Along a Demand Curve Elasticity is not the same as
slope. Elasticity changes along straight line supply and
demand curvesslope does not. The steeper the curve at a
given point, the less elastic is supply or demand. When the
curves are flat, we call the curves perfectly elastic.
Data for Calculating Elasticity at shaded section
Px Pz Y Qx
Price Point Elasticity:
2 1
1
2 1
1
5 4
100
100
4
1.75
6 7
100 100
7
Qx Qx
Qx
Px Px
Px

= =



Comment: We found negative but elastic relationship between price & quantity demanded, which
means the goods is normal goods.
Income Elasticity:
2 1
1
2 1
1
5 4
100
100
4
2
350 400
100 100
400
Qx Qx
Qx
Y Y
Y

= =



Comment: The income elasticity is negative & elastic that means the good is inferior goods.
Cross Elasticity:
2 1
1
2 1
1
5 4
100
100
4
1.63
15 13
100 100
13
Qx Qx
Qx
Pz Pz
Pz

= = +



Comments: The cross elasticity is positive and elastic. It means the good concerned is a substitute.
10 7 550 1
9 9 500 2
8 11 450 3
7 13 400 4
6 15 350 5
5 17 300 6
4 19 250 7
3 21 200 8
2 23 150 9
1 25 100 10

ln(Px) ln(Pz) ln(Y) ln(Qx)
_
2
R
0.995325
2.302585 1.94591 6.309918 0
F 639.7607
2.197225 2.197225 6.214608 0.693147
Coefficients Standard Error t Stat
2.079442 2.397895 6.109248 1.098612
Intercept -17.9002 4.19786 -4.26412
1.94591 2.564949 5.991465 1.386294
ln(Px) -1.41151 0.517016 -2.73011
1.791759 2.70805 5.857933 1.609438
ln(Pz) 2.633686 0.189811 13.87528
1.609438 2.833213 5.703782 1.791759
ln(Y) 2.549188 0.796466 3.200625
1.386294 2.944439 5.521461 1.94591 Qx is dependent variable. ln regression Px 1%
Qx 1.41% . This is elastic & negative so, it is normal. Y
1% Qx 2.54% . table table 1 t-test pass
analysis rejected t-test pass
_
2
R comment
1.098612 3.044522 5.298317 2.079442
0.693147 3.135494 5.010635 2.197225
0 3.218876 4.60517 2.302585

Use of Regression to Estimate Elasticity
Convert data into log (ln) then Run multiple regression. Discuss R2, F, t-statistics, DW etc. Comment on elasticities found.
Use b-values to estimate what would happen to quantity demand if things happen. Forecast demand.