ECONOMICS FOR MANAGERS

Economics is a social science that studies how society chooses to allocate its scarce resources, which have alternative uses, to provide goods and services for present and future consumption.

Content

Introduction, demand theory & analysis Cardinal and ordinal utility approach Revealed preference theory Price elasticity Production function Cost function Market structure Price and output decisions under different mkt structures, price discrimination Macro economics, monetary and fiscal policy

Consumer Demand
Demand is the mother of all production
Quantity Demanded refers to the amount (quantity) of a good that buyers are willing and able to purchase at alternative prices for a given period. High demand means high business prospects in future and vice versa.

Consumer Demand
Therefore it is essential for business managers to have a clear understanding of the following aspects of demand for their products: 1. What is the basis of demand for their commodity? 2. What are the determinants of demand ? 3. How do the buyers decide the quantity of a product to be produced ? 4. How do the buyers respond to change in the product prices, their incomes and prices of the related goods? 5. How can the total or market demand for a product be assessed and forecasted ?

Law of Demand
The Law of Demand states that as price of the commodity increases, the quantity demanded reduces and vise versa; other things remaining constant.

Factors Behind the Law of Demand :

1.

2.
3.

Substitution Effect. Income Effect Utility-Maximizing Behavior

Law of Demand
Exceptions to the Law of Demand :
1.

2. 3.

Expectations of further price rise in future. Status Goods. Giffen Goods

Basis of the Consumer Demand: Utility

Consumer's demand a product because they derive or except to derive utility from the consumption of that commodity. Utility is the power of a Commodity to satisfy human wants. Utility has a specific meaning and use in the analysis of consumer demand .

Basis of the Consumer Demand: Utility

The concept of utility can be looked upon from 2 angles: 1. Product Angle: Utility is a want satisfying property of a commodity or product. 2. Consumers Angle: Utility is a psychological feeling of satisfaction, pleasure, happiness and well-being, which a consumer derives from the consumption, possession or the use of a commodity.

Total and Marginal Utility

Total Utility: is defined as the sum of the
utility derived by a consumer from various units of goods and services consumed at a point or over a period of time . For Eg : A consumer consume 4 units of a commodity, X, at a time and derives utility from the successive units of consumption as U1, U2, U3 & U4. His total utility (Ux) from commodity X can be then measured as follows: Ux= U1 +U2 + U3 + U4

Total and Marginal Utility

If a consumer consumes n number of commodities, his total utility, TUn is the sum of the utility derived from each commodity. For instance, if the consumption goods are X, Y and Z and their total respective utilities are Ux, Uy and Uz, then TUn = Ux + Uy + Uz

Total and Marginal Utility

Marginal Utility : may be defines in number of ways. It is defined as the utility derived from the marginal or one additional unit consumed or It may be defined as the addition to the total utility resulting from the consumption of one additional unit Marginal Utility (MU) thus refers to the change in Total Utility ( TU) obtained from the consumption of an additional unit of a commodity, say X. It may be expressed as : MUx = TUx Qx

Law of Diminishing Marginal Utility

The law states that the more we have of a given product the less satisfaction (or utility) we receive from each additional unit (for example, the first slice of pizza delivers more pleasure than the second and this decreases with each additional slice).

Law of Diminishing Marginal Utility

Unit of Commodity X 0 1 2 3 4 5 Total Utility (TUx) 0 4 7 8 8 7 Marginal Utility (MUx) 0 4 3 1 0 -1

Total and Diminishing Marginal Utility of Commodity X

Assumptions to Law
1.

The unit of the consumer good must be standard one, eg a cup of tea, a bottle of cold drink, a pair of shoes etc. If the units are excessively small or large, the law may not hold. The consumer taste, preference must remain the same during the period of consumption.

2.

3.

There must be continuity in consumption. Where a break in continuity is necessary, the time interval between the consumption of two units must be appropriately short.

Assumptions to Law
4. The mental Condition of the consumer must remain normal during the period of consumption. In cases like accumulation of money, collection of stamps, old coins, rare paintings or melodious songs, the marginal utility may initially increase rather than decrease.

Marginal Utility of Money

Money is a general purchasing power. It enables a purchaser to buy anything he likes. That is why it is said one can never reaches a stage where money eases to be desired. That is the marginal utility of money goes on increasing with its increase. This is opposite to the law of diminishing marginal utility.

Marginal Utility and Price

The consumer stops where the price and marginal utility are equal. All units of a commodity being interchangeable, what is paid for the marginal unit is paid for every unit. Therefore can say that marginal utility determines price. It is marginal utility and not Total Utility that determines price.

Marginal Utility and Supply

Marginal Utility is a function of supply i.e it varies with supply. In case of a free good where supply is unlimited, the marginal utility is zero. Only in the case of scarce goods the marginal utility is positive. It increases as supply contracts and decreases as supply increases.

Analysis of consumer behaviour

CARDINAL APPROACH
This school believes that Utility is measurable and is a quantifiable entity. Cardinal Utility Approach attributed to Alfred Marshal and his followers, is also called the neo-classical approach, which gives exact measurement by assigning definite numbers such as 1,2,3, etc. Examples are temperature can be measured in degrees, distant can be measure in kilometers, weight, height, length and air pressures.

Assumptions:

Rationality Limited money income Maximisation of satisfaction Utility is cardinally measurable Diminishing marginal utility Constant marginal utility of money Utility is additive

Derivation of demand Curve in case of a single commodity

Dr. Alfred Marshall-was of the view that the law of demand and so the demand curve can be derived with the help of utility analysis. He explained the derivation of law of demand (i) in the case of a single commodity and (ii) in the case of two or more than two commodities: In the utility analysis of demand, the following assumptions are made.

Derivation of demand Curve in case of a single commodity

Dr. Alfred Marshall derived the demand curve with the aid of law of diminishing marginal utility. The law of diminishing marginal utility states that as the consumer purchases more and more units of a commodity, he gets less and less utility from the successive units of expenditure. At the same time, as the consumer purchases more and more units of one commodity, then lesser and lesser amount of money is left with him to buy other goods and services

Derivation of demand Curve in case of a single commodity

A rational consumer, therefore, while purchasing a commodity compares the price of the commodity which he has to pay with the utility of the commodity he receives from it. So long as the marginal utility of a commodity is higher than its price MUx > Px, the consumer would demand more and more units of it till its marginal utility is equal to its price MUx = Px or the equilibrium condition is established.

Derivation of demand Curve in case of a single commodity

To put it differently, as the consumer consumes more and more units of a commodity, its marginal utility goes on diminishing. So it is only at a diminishing price at which the consumer would like to demand more and more units of a commodity. This is explained with the help of the following diagram:

Derivation of demand Curve in case of a single commodity Law of Diminishing Marginal Utility

Derivation of demand Curve in case of a single commodity

In figure the Mux is negatively sloped. It shows that as the consumer acquires larger quantities of good x, its marginal utility diminishes. Consequently, at diminishing price, the quantity demanded of the good x increases as is shown in figure. At x, quantity the marginal utility of a good is Mu1. This is equal to p1 by definition.

Derivation of demand Curve in case of a single commodity

The consumer here demands Ox1 quantity of the commodity at P1 price. In the same way x2 quantity of the good is equal to p2. Here at P2 price, the consumer will buy ox2 quantity of commodity. At x3 quantity the marginal utility is Mu3, which is equal to p3. At p3, the consumer will buy ox3 quantity and so on.

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

The law of equi-marginal utility explains the consumer's equilibrium in a multi-commodity model. The law states that a consumer consumes various goods in such quantities that MU derived per unit of expenditure from each good is the same.

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

When a consumer has to spend a certain given income on a number of goods, he attains maximum satisfaction when the marginal utilities of the goods are proportional to their prices as stated below.

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

1. In the figure, given the money income, the price of x commodity (Px) and the price of Y commodity (Py) and constant marginal utility of money (MUm), the demand curve derived is illustrated. 2. The consumer allocates his money income between X and Y commodities to get OQ1 units of good x and OY unit of good Y commodities because the combination corresponds to at the OM level (constant).

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

3. Let us assume that money income and the price of Y commodity remain constant but the price of X commodity decreases. As a result of this money expenditure on commodity X rises resulting MUx/Px curve to shift to the right. 4. The consumer now allocates his income to OQ2 quantity of X commodity and OY quantity of Y commodity because the combination corresponds to MUx/Px =

MUy/Py=Mum (Constant).

Derivation of demand Curve in case of a single commodity Law of Equimarginal utility

5. Thus in response to decrease in the price from Px to Px1, the quantity demanded of a good X increases from OQ1 to OQ2. The DD is a negatively sloped demand curve.

Ordinal Utility Approach

According to this theory, utility cannot be measured in physical units rather the consumer can only rank utility derived from various commodities. Thus according to the ordinal utility approach is not additive. Hick used a different tool of analysis called Indifference Curve to analyze consumer behaviour.

Ordinal Utility Approach

This approach is based on the following assumptions: 1. Rationality: The consumer is assumed to be a rational being. Rationality means that a consumer aims at maximizing his total satisfaction given his income and prices of commodities that he consumes and his decisions are consistent with this objective.

Ordinal Utility Approach

2. Ordinal Utility: Indifference curve analysis
assumes that utility is only ordinally expressible. That is, the consumer is only able to express the order of his preference for different baskets of goods.

3. Transitivity and Consistency of choice: Consumers choice are summed to be transitive. Transitivity of choice means that a consumer prefers A TO B and B to C, he must prefer A to C, or if he must treat A=B and B=C, he must treat A=C.

Ordinal Utility Approach

4. Nonsatiety: It is also assumed that consumer is never
over-supplied with goods in question. That is, he has not reached the point of saturation in case of any commodity. Therefore, a consumer always prefers a larger quantity of all goods. 5. Diminishing Marginal Rate of Substitution: This is a rate at which a consumer is willing to substitute one commodity (X) for another commodity (Y) so that his total satisfaction remains the same. If the marginal rate of substitution is given as DY/DX , the ordinal utility approach assumes that DY/DX goes on decreasing when consumer continues to substitute X for Y.

Indifference curve

Locus of points, each represents a different combinations of two substitutes goods, which yield the same utility or satisfaction to the consumers.

It has a negative slope Convex to the origin Do not intersect nor tangent to other IC Upper IC indicates higher level of satisfaction.

Budget line

Shifts in budget line

Consumer equilibrium