Business Economics

(1) Define Business Economics & Explain its characteristics?

Business economics is the discipline which helps a business manager in decision making for
achieving the desired results. in other words, it deals with the application of economic theory
to business management.
(1) Business Economics is The integration of economics theory with business
practise for the purpose of facilitating decision-making and forward planning
by management.
- Spencer and Siegelman
(2) Business economics deals with the use of economic modes of thought to
analyse business situation.
-Mc Nair and Mariam

Characteristics

Micro in Nature-Business economics is micro - economics in nature.This is due to

the study of business economics mainly at the level of the firm.Generally a business
manager is concerned with the problems of his own business unit.He does not study
the economic problems of an economy as a whole.
Basis of Theory of Markets and Private Enterprises Business economics largely
uses the theory of markets and private enterprises.It uses the theory of the firm and
resource allocationof privateenterprise economy.
Pragmatic in Approach Business economics is pragmatic in its approach.Its does
not involve itself with the theoretical controversies of economics.Yet it does not
regulate the realities of business decisions-making to the background by bringing in
abstract assumptions.While economic theory abstracts from realities of the individual
business units to build up its theories,managerial economics takes proper note of the
particular economic environment in which a firm works.
Normative in Nature Business economics is called normative economics which
prescribes standards or norms for policy making.Business economics in prescriptive
rather than descriptive in nature.In economic theory,we try to explain economic
behaviour:in business economics,we try to prescribe policies for a business manager
which are most likely applied to achieve his objectives.In economic theory, we build
laws such as the law of Demand and the Law of Diminishing Returns.In business
economicswe apply these laws for policy planning at the level of a firm.
Macro Analysis Macro economics which deals with the principles of economic
behaviour for the economy as a whole is also useful for business economics. A
business unit operates within some economic environment which is in turn shaped by
the behaviour of the economy as a whole. Therefore, business manager must know the
external forces working over his business environment. He has to adjust himself to the
uncertainties of his business in wise manner.
Conceptional Business economics is conceptional.It means that conceptional tools
can be used for the quantitive techniques.Thus,it is used to understandand analyse the
decision problems.
Economic Concepts Managerial economics uses economic concepts and principles.
In, fact it is useful to apply economic theory to practical problems.
 Business Economics

(2) Explain the Objective four scopes of business economics?

Managerial Economics is a developing science which generates the countless
problems to determine its scope in a clear-cut way. Even than the following fields may be
said to generally fall under business economics:
1. Demand Analysis and forecasting.
2. Cost and Production Analysis.
3. Pricing Decisions, Policies and Practices.
4. Profit Management.
5. Capital Management.
The study of these segment of business economics constitute its subject matter as well
as scope. Recently, managerial economics have started making increased use of operational
research methods like programming, games theory, queing up theory and input-output. Thus,
modern business economics includes a study of these methods as well. let us make an in-
depth study of these aspects.

Demand analysis and forecasting The foremost aspect regarding its scope is in
demand analysis and forecasting. A business firm is an economic unit which
transforms productive resources into saleable goods. Since all output is meant to be
sold, accurate estimates of demand help a firm in minimising its cost of production
and storage. A firm must decide its total output before preparing its production
schedule and deciding on the resources to be employed. Demand forecasts serves as
a guide to the management for maintaining its market share in competition with its
rivals, thereby securing its profit. Dhus demand analysis facilitates the
identification of the various factor affecting the demand for a firms product. This,
in turn, helps the firm in manipulating the demand for its output. In fact, demand
forecasts are the starting point for a firms planning and decision- making. This
deals with the basic tools of demand analysis i:e demand determinations and
demand forecasting etc.
Cost and production Analysis A firms profitability depends much on its costs of
production. A wise manager would prepare cost estimates of a range of output,
identify the factors causing variations in cost and choose the cost-minimising
output level, taking also into consideration the degree of uncertainly in production
and cost calculations. Production processes are under the charge of engineers but
the business manager works to carry out the production function analysis in order to
avoid wastages of materials and time. sound pricing policies depend much on cost
control. The main topics discussed under cost and production analysis are: cost
concepts, cost-output relationship, economics and diseconomics of scale and cost
control.
Pricing Decisions, Policies and Practices Another task before a business
manager is the pricing of a product. since a firms income and profit depends mainly
on the price decision, the pricing policies and all such decisions are to be taken after
careful analysis of the nature of the market in which the firm operates. Important
topics covered in this field of study are : market structure analysis, Pricing practices
and price forecasting.
 Business Economics

Profit Management Each and every business firm is tended for earning profit, it
is profit which provides the chief measure of success of a firm in the long period.
Economists tell us that profits are the reward for uncertainty bearing and risk
taking. A successful business manager is one who can form more or less correct
estimates of costs and revenues at different levels of output. the more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. It is
therefore, profit-planning and profit measurement that constitute the most
challenging area of business economics.
Capital Management Still another most challenging problem for a modern
business manager is of planning capital investment. Investment are made in the
plant and machinery and building which are very high. therefore, capital
management requires top-level decisions. It means capital management i.e.,
planning and control of capital expenditure. It deals with : cost of capital, Rate of
Return and selection of projects.
Capital and Investment Capital and investment are the life and blood of modern
business. thus, it highlights proper selection of investment project, efficient
allocation of capital and minimising the possibility of under capitalization and over
capitalization.
Environmental Issues The scope of managerial or business economics can also
be examined in the context of social and political environment of business firms.
Resource Allocation The resources are scarce. Proper allocation of resources
becomes the key need of each and every business. There are two main problems
like (i) to attain optimum and (ii) when the price of input increases what possible
substitutes should be used.

Que:(3) Explain the law of equi-marginal utility between imperial evidence?

Ans: The Law of equi marginal Utility is another fundamental principle of Econo-
mics. This law is also known as the Law of substitution or the Law of Maximum Satisfaction.

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

Explanation of the Law:

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

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

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

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

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

Diagrammatic Representation:

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

The consumer will gain maximum satisfaction if he spends OM money (3 rupees) on apples
and OM money (4 rupees) on oranges because in this situation the marginal utilities of the
two are equal (PM = PM). Any other combination will give less total satisfaction.

Let the purchase spend MN money (one rupee) more on apples and the same amount of
money, NM'( = MN) less on oranges. The diagram shows a loss of utility represented by the
shaded area LNMP and a gain of PMNE utility. As MN = NM and PM=PM, it is
proved that the area LNMP (loss of utility from reduced consumption of oranges) is bigger
than PMNE (gain of utili

ty from increased consumption of apples). Hence the total utility of this new combination is
less.
 Business Economics

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

Limitations of the Law of Equimarginal Utility:

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

(i) Ignorance:

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

(ii) Inefficient Organisation:

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

(iii) Unlimited Resources:

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

(iv) Hold of Custom and Fashion:

A consumer may be in the strong clutches of custom, or is inclined to be a slave of fashion. In

that case, he will not be able to derive maximum satisfaction out of his expenditure, because
he cannot give up the consumption of such commodities. This is specially true of the
conventional necessaries like dress or when a man is addicted to some intoxicant.

(v) Frequent Changes in Prices:

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

Practical Importance of the Law of Substitution:

The law of substitution is of great practical importance. Everybody has got limited income.
Naturally he must try to make the best use of it.

This can be done by the application of this law in the various aspects of economic life as
under:
 Business Economics

(i) Consumption:

A wise consumer consciously acts on this law while arranging his expenditure. His
expenditure is so distributed that the same price measures equal utilities at the margin of
different purchases. Every person must try to spend his income in a manner which yields him
the greatest satisfaction. This he will be able to do only if he spends his money in such a
manner as to obtain equal satisfaction from the marginal units of money spent on the various
commodities he purchases.

(ii) Production:

The law is also of great importance in production. The producer has to use several factors of
production. He wants maximum net profit. For this purpose, he must substitute one factor for
another so as to have the most economical combination, for example, he will substitute labour
for machinery and vice versa, So that the marginal utility or marginal productivity of the two
is equalised in this manner, he will get most economical combination of the actors of
production at his disposal to make maximum profit.

(iii) Exchange:

The law also applies in exchange because exchange is nothing else but substitution of one
thing for another. When we sell a commodity, say, sugar, we get money. With this money, we
buy another commodity, say, wheal. We have, therefore, really substituted sugar for wheat.

(iv) Distribution:

It is on the principle of marginal productivity that the share of each factor of production (viz.,
land, labour, capital, organisation) is determined. The use of each factor is pushed up to a
point where its marginal product is equal to the marginal product of every other factor, of
course after allowing for the differences in their respective remunerations. This necessitates
substituting one factor for another.

(v) Public Finance:

The Government, too, is guided by this law in public expenditure. The public revenues are so
spent as to secure maximum welfare for me community. The Government must cut down all
wasteful expenditure while the return is not proportionate and instead concentrate its
resources on more productive or more beneficial expenditure.

(vi) Influences Prices:

The law of substitution influences prices. When a commodity becomes scarce and its price
soars high, we substitute for it things which are less scarce. Its price, therefore, comes down.

(4) Explain the law of Diminishing Marginal Utility and discuss the
various exceptions in the law?
 Business Economics

Law of Diminishing Marginal Utility is an important law of utility analysis. This law is
related to the satisfaction of human wants. All of us experience this law in our daily life. If
you are set to buy, say, shirts at any given time, then as the number of shirts with you goes on
increasing, the marginal utility from each successive shirt will go on decreasing. It is the
reality of a mans life which is referred to in economics as law of Diminishing Marginal
Utility. This law is also known as Gossens First Law.
According to Chapman, The more we have of a thing, the less we want additional
increments of it or the more we want not to have additional increments of it.
According to Marshall, The additional benefit which a person derives from a given stock of
a thing diminishes with every increase in the stock that he already has.
According to Samuelson, As the amount consumed of a good increases, the marginal utility
of the goods tends to decrease.
In short, the law of Diminishing Marginal Utility states that, other things being equal, when
we go on consuming additional units of a commodity, the marginal utility from each
successive unit of that commodity goes on diminishing.

Assumptions :
Every law in subject to clause other things being equal This refers to the assumption on
which a law is based. It applies in this case as well. Main assumptions of this law are as
follows:
1. Utility can be measured in cardinal number system such as 1,2,3
_______ etc.
2. There is no change in income of the consumer.
3. Marginal utility of money remains constant.
4. Suitable quantity of the commodity is consumed.
5. There is continuous consumption of the commodity.
6. Marginal Utility of every commodity is independent.
7. Every unit of the commodity being used is of same quality and size.
8. There is no change in the tastes, character, fashion, and habits of the
consumer.
9. There is no change in the price of the commodity and its substitutes.

Explanation of the Law :

The Law of Diminishing Marginal Utility can be explained with the help
of Table and Figure.
No. of Breads Marginal Utility
1 8
2 6
3 4
4 2
5 0point of Satiety
6 -2
It is clear from the above Table that when the consumer consumes first
unit of bread, he get marginal utility equal to 8. Marginal utility from the
consumption of second, third and fourth bread is 6, 4 and 2 respectively. He
gets zero marginal utility from the consumption of fifth bread. This is known as
point of satiety for the consumer. After that he gets negative utility i.e. -2 from
the consumption of sixth unit of bread. Thus, the table shows that as the
consumer goes on consuming more and more units of bread, marginal utility
 Business Economics

goes on diminishing.

(5) Explain the indifference analysis.

Indifference Curve approach was first propouned by British economist Edgeworth in 1881 in
his book Mathematical Physics. The concept was further developed in 1906 by Italian
economist Pareto, in 1913 by British economist W .E. Johnson, and in 1915 by Russina
economist Stutsky. The credit of rendering this analysis as an important tool of theory of
Demand goes to Hicks and Allen. In 1934, they presented it in a scientific form in their
article titled A Reconsideration of the Theory of Value. It was discussed in detail by
Hicks in his book, Value and Capital.
An indifference curve is a geometrical presentation of a consumer is scale of preferences. It
represents all those combinations of two goods which will provide equal satisfaction to a
consumer. A consumer is indifferent towards the different combinations located on such a
curve. Since each combination located on such a curve. Since each combination yields the
same level of satisfaction, the total satisfaction derived from any of these combinations
remains constant.
An indifference curve is a locus of all such points which shows different combinations of two
commodities which yield equal satisfaction to the consumer. Since the combination
represented by each point on the indifference curve yields equal satisfaction, a consumer
becomes indifferent about their choice. In other words, he gives equal importance to all the
combinations on a given indifference curve.
According to ferguson, An indifference curve is a combination of goods, each of which
yield the same level of total utility to which the consumer is indifferent.
According to leftwitch, A single indifference curve shows the different combinations of X
and y that yield equal satisfaction to the consumer.

Indifference Schedule :
An indifference schedule refers to a schedule that indicates different combinations of two
commodities which yield equal satisfaction. A consumer, therefore, gives equal importance to
each of the combinations:
Supposing a consumer two goods, namely apples and oranges. The following indifference
schedule indicates different combinations of apples and oranges that yield him equal
satisfaction.

Combination of Apple Oranges

Apples and Oranges
A 1 0
B 2 7
C 3 5
D 4 4

The above schedule shows that the consumer get equal satisfaction from all the four
combinations, namely A, B, C and D of apples and oranges. In combination A the consumer
has I apple + 10 oranges, in combination B he has 2 apples +7 oranges, in combination C he
has 3 apples +5 oranges, and in Combination D he has 4 apples + 4 oranges. In order to have
one more apple the consumer sacrifice, some of the oranges in such a way that there is no
change in the level of his satisfaction out of, each combination.
 Business Economics

Indifference Curve :
Indifference curve is a diagrammatic representation of indifference schedule. The
indifference curve shown in figure 1 is based on Table No.1 In this diagram, quantity of
apples is shown on ox-axis and that of oranges on oy-axis. IC is an indifference curve.
Different points A,B,C, and D on it indicate those combinations of apples and oranges which
yield equal satisfaction to the consumer.

Some Exceptional Shapes of Indifference Curves :

Some sectional shapes of indifference curves are as follows:

1. Straight Line Indifference Curve :

If two goods are perfect substitutes of each other then their indifference curve may be a
straight line with negative slope. It is so because the marginal rate of substitution of such
goods remains constant. Supposing, Brook Bond and Lipton tea are perfect substitutes of
each other. If in place of 1 kg. of Brook Bond tea the consumer buys 1 Kg. of Lipton tea his
total satisfaction remains unchanged. As such, indifference curve for such kind of goods will
not be convex to the origin, rather it will be a straight line. Marginal rate of
substitution (MRS) of such good goods is always equal to one.

2. Right angled Indifference Curves: Marginal rate of substitution (MRS)

of perfectly complementary goods is zero. For example, a consumer will buy right and left
shoes in a fixed ratio as shown in diagram. It is clear that IC1 and IC2 are right angel curves,
meaning thereby that if the consumer buys one piece of each of right and left-shoes, he
will be on point A of IC1. In case he buys 2 pieces of left shoe and only 1 piece of right shoe,
he will be at C of the same IC1. It means, his satisfaction will remain the same. But if he also
buys one more piece of right-shoe, his satisfaction will definitely increase and he will move
to point B of higher indifference curve IC2. Thus, perfectly complementary goods have
indifference curves of the shape of right angle. Marginal rate of substitution in the case of
such goods is zero (MRSxy = O).

Price Line or Budget Line :

Study of price line is essential to have the knowledge of consumer equilibrium through
indifference curve analysis. It is also known as Budge line, consumption possibility line, or
line of attainable combinations.
A price line represents all possible combinations of two goods, that consumer can purchase
with his given income at the given prices of two goods

(6) Critically evaluate the consumer surplus?

Thus, Marshall defines the consumers surplus in the following words: excess of the price
which a consumer would be willing to pay rather than go without a thing over that which he
actually does pay is the economic measure of this surplus satisfaction. it may be called
consumers surplus.
 Business Economics

The concept of consumer surplus was first formulated by Dupuit in 1844 to measure social
benefits of public goods such as canals, bridges, national highways. Marshall further refined
and popularised this in his Principles of Economics published in 1890.

The concept of consumer surplus became the basis of old welfare economics. Marshalls
concept of consumers surplus was based on the cardinal measurability and interpersonal
comparisons of utility. According to him, every increase in consumers surplus is an indicator
of the increase in social welfare. As we shall see below, consumers surplus is simply the
difference between the price that one is willing to pay and the price one actually pays for a
particular product.

Critical Evaluation of the Concept of Consumers Surplus:

The concept of consumers surplus has been severely criticised ever since Marshall
propounded and developed it in his Principles of Economics. Critics have described it as
quite imaginary, unreal and useless. Most of the criticisms of the concept have been levelled
against the Marshallian method of measuring it as an area under the demand curve. However,
some critics have challenged the validity of the concept itself.

Marshallian concept of consumers surplus has also been criticised on the ground of its being
based upon unrealistic and questionable assumptions.

Uses and Applications of Consumer Surplus:

The concept of consumer surplus has several applications both in economic theory and
economic policy. This concept has been used to resolve water-diamond paradox of value
theory, to explain the effects of taxes and subsidies on peoples welfare, to make cost-benefit
analysis of public projects, to show gains from trade etc.

(7) Explain the consumer equilibrium to indifference curve techniques?

The consumers equilibrium under the indifference curve theory must meet the following two
conditions:

(i) MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumers equilibrium is that

MRSXY = PX/PY

a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price
prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till
it becomes equal to the ratio of prices and the equilibrium is established.
 Business Economics

b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price
prevailing in the market. It induces the consumer to buys less of X and more of Y. As a
result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.

(ii) MRS continuously falls:

The second condition for consumers equilibrium is that MRS must be diminishing at the
point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of
equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.

Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

Let us now understand this with the help of a diagram:

In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line.
With the constraint of budget line, the highest indifference curve, which a consumer can
reach, is IC2. The budget line is tangent to indifference curve IC2 at point E. This is the
point of consumer equilibrium, where the consumer purchases OM quantity of commodity
X and ON quantity of commodity Y.

All other points on the budget line to the left or right of point E will lie on lower
indifference curves and thus indicate a lower level of satisfaction. As budget line can be
tangent to one and only one indifference curve, consumer maximizes his satisfaction at point
E, when both the conditions of consumers equilibrium are satisfied:

(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference curve (MRS between
X and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established
at any other point as MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at
all points to the right of point E. So, equilibrium is established at point E, when MRS XY =
PX/PY.

(ii) MRS continuously falls:

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The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC 2 is
convex to the origin at point E.

(8) What does the law of demand means explain the factors the influence
the demand for a product in market?

THE LAW OF DEMAND

The law of demand states that the demand for a commodity increases when its price
decreases and it falls when its price rises, other things remaining constant. This is an
empirical law, i.e., this law is based on observed facts and can be verified with new empirical
data. As the law 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 include other determinants of demand, viz., consumers income, price of the
substitutes and complements, taste and preferences of the consumer, etc.
These factors remain constant only in the short run. In the long run they tend to change. The
law of demand, therefore, hold only in the short run.

Demand Schedule
The law of demand can be presented through a demand schedule.
Demand Schedule is a series of prices placed in descending (or ascending) order and the
corresponding quantities which consumers would like to buy per unit of time. Based on the
logic of demand curve in Fig. 4.1 (b), a hypothetical demand schedule for a commodity, tea,
is given in Table 4.1

Table 4.1 Demand Schedule for Tea

Price per cup of No. of cups of tea Points representing
tea (Rs.) demand by a Price-quantity
consumer per day combination
7 1 i
6 2 j
5 3 k
4 4 I
3 5 m
2 6 n
1 7 0
4.1 presents seven alternative prices of tea and the corresponding quantities (number of cups
of tea) demanded per day. At each price, a unique quantity is demanded. As the table shows,
as price of tea per cup decreases, daily demand for tea increases. This relationship between,
quantity demanded of a product and its price is the basis of the law of demand.

The Demand Curve

The law of demand can also be presented through a demand curve. A demand curve is a
locus of points showing various alternative pricequantity combinations. Demand curve
shows the quantities of a commodity which a consumer would buy at different prices

Substitution Effect
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When price of a commodity falls, prices of all other related goods (particularly of substitutes)
remaining constant, the goods of latter category become relatively costlier. Or, in other
words, the commodity whose price has fallen becomes relatively cheaper. Since utility
maximising consumers substitute cheaper goods for costlier ones, demand for the cheaper
commodity increases. The increase in demand on account of this factor is known a

Income Effect
As a result of fall in the price of a commodity, the real income of the consumer increases.
Consequently, his purchasing power increases since he is required to pay less for the same
quantity. The increase in real income encourages the consumer to demand more of goods and
services. The increase in demand on account of increase in real income is known as income
effect. It should however be noted that the income effect is negative in case of inferior
goods. In case the price of an inferior goods accounting for a considerable proportion of the
total consumption expenditure falls substantially, consumers real income increases and they
become relatively richer: Consequently, they substitute the superior goods for the inferior
ones. As a result, the consumption of inferior goods falls. Thus, the income effect on the
demand for inferior goods becomes negative.

Utility-Maximising Behavior
The utility-maximising behavior of the consumer under the condition of diminishing
marginal utility is also responsible for increase in demand for a commodity when its price
falls. As mentioned above, when a person buys a commodity, he exchanges his money
income for the commodity in order to maximise his satisfaction. He continues to buy goods
and services so long as marginal utility of his money (MUm) is less than the marginal utility
of the commodity (MUo). Given the price of a commodity, the consumer adjusts his
purchases. so that.
MUm = Po = MUo
When price of the commodity falls, (MUm = Po) < MUo, and equilibrium is disturbed. In
order to regain his equilibrium, the consumer will have to educe the MUo to the level of
MUm. This he can do only by purchasing more of the commodity. Therefore, the consumer
purchases the commodity till Mum = Po = MUo. This is another reason why demand for a
commodity increases when its price decreases.

Exceptions to the Law of Demand

The law of demand does not apply to the following cases.

(a) Expectations regarding further prices. When consumers expect a continuous increase
in the price of a durable commodity, they buy more of it despite increase in its price with a
view to avoiding the pinch of a much higher price in future. For instance, in pre-budget
months, prices generally tend to rise.
Yet, people buy more of storable goods in anticipation of further rise in prices
due to new levies.

(b) Status Goods. The law does not apply to the commodities which are used as a status
symbol of enhancing social prestige or for displaying wealth and riches, e.g., gold, precious
stones, rare paintings, antiques, etc. Rich people buy such goods mainly because their prices
are high and buy more of them when their prices move up.

(c) Giffen Goods. Another exception to the law of demand is the classic case of Giffen
goods2. A Giffen good may be any inferior commodity much cheaper than its superior
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substitutes, consumed by the poor households as an essential commodity. If price of such

goods increases (price of its substitute remaining constant), its demand increases instead of
decreasing because, in case of a Giffen good, income effect of a price rise is greater than its,
substitution effect. The reason is, when price of, an inferior good increases, income
remaining the same, poor people cut the consumption of the superior substitute so that they
may buy more of the inferior good in order to meet their basic need.

SHIFT IN DEMAND CURVE

When demand curve changes its position (retaining its shape though not necessarily), the
change is known as shift in demand curve. Consider, for instance, the demand curves viz. D1,
D2 and D3 in Fig. 4.3. Let us suppose that demand curve D2 is the original demand curve for
commodity X. As shown in the figure, at price OP2. Consumer buys OQ2 units of X, other
factors remaining constant. But, if any of the other factor (e.g. consumers in come or price of
the substitutes) changes, it will change the consumers ability and willingness to buy
commodity X. For example, if consumers disposable income decreases due to increase in
income tax, he may be able to buy only OQ1 units of X instead of OQ2. The is true for the
whole range of prices of X; consumers would be able to buy less at all other prices. This will
cause a downward shift in demand curve D2 to D1. Similarly, increase in disposable income
of the consumer due to, say, reduction in taxes may cause an upward shift in D2 to D3.
Such changes in the location of demand curves are known as shift in demand curve.

Reasons for Shift in Demand Curve

Shifts in a price-demand curve may take place owing to the change in one or more
determinants of the demand for a commodity. Consider, for example, the decrease in demand
for commodity X by Q1 Q2 in Fig. 4.3. Given the price OP2, the demand for x might have
fallen from OQ2 to OQ1 (i.e., by Q1Q2) for any of the following reasons.
(i) Fall in consumers income so that he can buy only OQ1 of X at price OP2; it is income
effect;
(ii) Price of Xs substitute falls so that the consumers find it worthwhile to substitute Q1 Q2of
X with its substitute; it is substitution effect;
(iii) Advertisement made by the producer of the substitute, changes consumers taste or
preference against commodity X so much that they replace Q1 Q2 of it with its substitute,
again a substitution effect ;
(iv) Price of complement of X has increased so much that the consumer can now afford only
OQ1 of X; and
(v) Price remaining the same, demand for X might also decrease for such reasons as X going
out it of fashion, deterioration in its quality, change in consumers technology and seasonality
of the product

DETERMINANTS OF MARKET DEMAND

(1) Price of the Product

The price of product is one of the most important determinants of its demand in the long run,
and the only determinant in the short run. The price and quantity demand are inversely
related. The law of demand states that the quantity demanded of a product which its
consumers/users would like to buy per unit of time, increases when its price falls, and
decreases when its price increases, other factors remaining constant. The assumption other
factors remaining constant implies that income of the consumers, prices of the substitutes
and complementary goods, consumers taste and preference, and number of consumers,
 Business Economics

remain unchanged. (The law of demand has already been discussed in detail in the previous
chapter).

(2) Price of the Related Goods

The demand for a commodity is also affected by the changes in the price of its related goods.
Related gods may be substitutes or complementary goods.

Substitutes. Two commodities are deemed to be substitutes for each other if change in the
price of one affects the demand for the other in the same direction. F or instance,
commodities X and Y are considered as substitutes for each other if a rise in the price of X
increases demand for Y2 and vice versa.
Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some examples
of substitutes in case of consumer goods.
By definition, the relation between demand for a product and price of its substitute is of
positive nature. When price of the substitute (say, coffee) of a product (tea) falls (or
increases), the demand for the product falls (or increases).

(9) What is means by price elasticity of demand?

Price elasticity of demand is generally defined as the responsiveness or sensitiveness of

demand for a commodity to the changes in its price. More precisely, elasticity of demand is
the percentage changes in demand as a result of one per cent in the price of the
commodity. A formal definition of price-elasticity of demand (ep) is given as
Percentage change in quantity demanded

ep ==

Percentage change in price A general formula2 for calculating coefficient of price-elasticity,

derived from this definition of elasticity, is given as follows. where Q = original quantity
demanded, P = original price, DQ = change in quantity = demanded, and DP = change in
price.
It is important to note here .that, a minus sign (-) is generally inserted in the formula before
the fraction with a view to making elasticity coefficient a nonnegative value.
The elasticity can be measured between two points on a demand curve (called are elasticity)
or on a point (called point elasticity).

Arc Elasticity
The measure of elasticity of demand between any two finity points on a demand curve in
known as are elasticity. For example, measure of elasticity between points j and k (Fig. 4.9) is
the measure of arc elasticity. The movement from point j to k on the demand curve (Dx)
shows a fall in the price Rs.20 Rs.10 so that DP = 20 10 = 10. The fall in price increases
demand from 43 units to 75 units so that DQ = 43-75 = -32. The elasticity between points)
and k (moving from) to k) can be calculated by substituting these values into the
elasticity formula as follows :

1.49
It means, a one percent decrease in price of commodity X results into a 1.49 per cent increase
in demand for it.
 Business Economics

Problem in using are elasticity. The are elasticity should be measured, interpreted and used
carefully, otherwise it may lead to wrong decisions. Are elasticity co-efficients differ between
the same two finite points on a demand curve if direction of change in price is reserved. For
instance, as estimated in Eq. (4.7), the elasticity between points j and k

(10) Explain the long term forecasting?

Since the 1970s much work has been done developing and improving long-term energy
forecasting methods. Forecasters typically use 1 of 5 methods or a combination of these:
trend projections, econometric analysis, scenario analysis, end-use analysis and systems
dynamics. This article discusses each of these methods, their pros and cons, and their
suitability for different purposes. This is the second of a 3-part series on long-term energy
forecasts. The first installment discussed the necessity and value of long-term energy
forecasts.

Categories of Long-Term Energy Forecasting Methods

Following Craig, Gadgil and Koomey, I have categorized these 6 long-term forecasting
methods by the intent of the forecast: what-is-likely, what-is-possible or both. This
classification scheme focuses on the goal of the forecast instead of the characteristics of the
method itself.

Method What-Is-Likely What-Is-Possible

Trend Projections X
Econometric Analysis X
Scenario Analysis X
Systems Dynamics X
End-Use Analysis X
Combinations or Hybrids X X

Description of the What-Is-Likely Long-Term Energy Forecasting Methods

Both trend projections and econometric analysis are top-down methods which assume that
what is likely to happen can be predicted from past and current trends. Therefore, both
require extensive historical data and assume no significant changes occur in the system being
analyzed during the forecast period. Neither method is suited to emerging nations because
these countries dont have the necessary data and even if they did, their past energy demand
has little to do with their future requirements due to expected technological, structural and
economic changes.

1. Trend Projections

Trend projections are naive methods, in that they dont try to explain energy consumption.
They are simple extrapolations of time series data, relating energy use to a chosen variable,
such as GDP, using ordinary least squares analysis. They can be linear, semi-log or log-log.
 Business Economics

Their advantage is simplicity.

Their disadvantages are the need for large amounts of historical data, the inability to identify
any emerging changes or accommodate them and the discouragement of a search for driving
forces.

Trend projections are best suited for short time periods in developed nations.

2. Econometric Analysis

Econometric methods are named after the practitioners which have influenced them the most,
economists. They are causal methods because they attempt to explain energy consumption
based on changes in energy prices, consumer income and other economic factors. These
complex, multivariate regressions seek an optimal solution.

On the plus side is their ability to find optimized quantitative relationships between
dependent variables like energy consumption and many independent variables like energy
cost. Therefore, econometric methods can be used for price-based policy decisions.

On the minus side, econometric analyses are complex and require considerable expertise to
implement. They are also data intensive and assume the structure of the system is static. The
implicit assumption of perfect competition (no monopolies, no users have market power, no
subsidies, and all markets in equilibrium) is questionable even for developed nations. And
the assumption that energy consumption is the only factor in technology selection is
unrealistic. Moreover, complexity doesnt always produce better results.

Like trend analysis, econometric analysis is best suited for short-time periods in developed
nations.

Description of the What-Is-Possible Long-Term Energy Forecasting Methods

1. Scenario Analysis

Scenario analysis was developed as a strategic management tool in 1960. Scenarios are
stories about possible energy futures. Scenario analysis is different from most other
forecasting methods in that it considers a range of outcomes rather than trying to identify the
most likely one.

The advantages of scenario analysis are it is not data intensive and can easily incorporate
technological and social disruptions and substitutions (for example, battery-electric
vehicles). It can get people to consider alternatives they had not previously considered. It
can include factors affecting developing countries such as the division between rich/poor and
urban/rural consumers, the continued use of traditional fuels such as wood and significant
numbers of non-cash transactions which cannot be easily included in other methods. And, it
can factor in developing countries potentially leapfrogging their energy sources by
jumping directly to renewables instead of following the path:

biomass - coal - oil & gas - nuclear - wind and solar

(Hydro can appear anywhere in this path.)
 Business Economics

While the technical skill required to apply scenario analysis is less than for econometric
analysis, crafting comprehensive scenarios which include the possibility of structural changes
is not trivial. Scenario analysis alone cannot be used for price-based policy decisions.

Scenario analysis is well-suited to deal with uncertainties in demand and is especially ideal
for developing nations. A long-term energy forecasting model know as LEAP (Long-Range
Energy Alternatives Planning) relies mainly on scenario analysis and is used by some 85
countries.

2. End-Use Analysis

End-use analysis is a bottom-up engineering-economic method that was first used for energy
forecasting in France in 1978. It separates or disaggregates total energy consumption into
several major sectors: industrial, commercial, residential and transport. Within these sectors,
the amount of energy used for various purposes or end uses is assessed (heating, cooling,
lighting, etc.) to forecast total energy use. End-use models can use optimization or
simulation to generate forecasts. Scenarios are used as well.

The advantages of end-use analysis are the ability to incorporate changes in technology,
energy and policy, physical limits on equipment performance and saturation effects. For
example, the percentage of homes with air-conditioning cant be more than 100%.

The disadvantages are the need for data on end uses and the potential to be overly optimistic
or pessimistic with regard to the introduction and adoption of new technologies.

3. Systems Dynamics

Systems dynamics was developed in the 1950s to determine why employment at GE

appliance plants in Kentucky followed a 3-year cycle and was first used for energy
forecasting in the 1970s. It is based on process engineering with its stock-flow-feedback
paths. Technical, social and economic systems are considered as combinations of buckets
which can accumulate and discharge energy, population and money, respectively. The
interconnecting paths among these buckets allow for feedback. The model must be precisely
specified to permit solution of the differential equations that define it.

The pluses of systems dynamics are explicit assumptions. Unlike econometric and end-use
analysis where exponential growth is often an implicit assumption, systems dynamics
requires the forecaster to identify the feedback process responsible for exponential growth or
decay.

Technical complexity is a disadvantage.

Systems dynamics has not been widely used for energy policy decisions. It is not clear why,
but its use by the authors of the controversial book, The Limits to Growth, may be a factor.

(11) What is significant demand forecasting?

 Business Economics

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It helps an organization to
reduce risks involved in business activities and make important business decisions. Apart
from this, demand forecasting provides an insight into the organizations capital investment
and expansion decisions.

The significance of demand forecasting is shown in the following points:

i. Fulfilling objectives:

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

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

ii. Preparing the budget:

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

iii. Stabilizing employment and production:

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

according to the forecasted demand of products helps in avoiding the wastage of the
resources of an organization. This further helps an organization to hire human resource
according to requirement. For example, if an organization expects a rise in the demand for its
products, it may opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

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

v. Taking Management Decisions:

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

vi. Evaluating Performance:

 Business Economics

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

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international
trade.

(12) Explain different method of forecasting?

TECHNIQUES OF FORECASTING DEMAND

Survey Method : Survey method are generally used where purpose is to make shortrun
forecast of demand. Under this method, surveys are conducted to collect information about
consumers intentions and their future purchase-plans. This method includes :
(i) survey of potential consumers to elicit information on their intentions and plan;
(ii) opinion polling of experts, i.e., opinion survey of market experts and sales representative,
and through market studies and experiments.
The following techniques are used to conduct the survey of consumers and experts.

Consumer Survey Methods :

The consumer survey method of demand forecasting involves direct interview of the potential
consumers. It may be in the form of: complete enumeration, or sample survey.
These consumer survey methods are used under different conditions and for different
purposes. Their advantages and disadvantages are described below.

Direct Interview Method :

The most direct and simple way of assessing future demand for a product is to interview the
potential consumers or users and to ask them what quantity of the product they would be
willing to buy at different prices over a given period say, one year. This method is known as
direct interview method. This method may, cover almost all the potential consumers or only
selected groups of consumers from different cities or parts of the area of consumer
concentration. When all the consumers are interviewed, the method is known as complete
enumeration survey method, and when only a few selected representative consumers are
interviewed, it is known as sample survey method. In case of industrial inputs, interview of
postal inquiry of only endusers of a conduct may be required. These are described as follows

Complete Enumeration Method :

In this method, almost all potential users of the product are contacted and are asked about
their future plan of purchasing the product in question. The quantities indicated by the
consumers are added together to obtain the probable demand for the product. For example, if
only n out of m number of households in a city report the quantity (d) they are willing to
purchase of a commodity, then total probable demand (D) may be calculated as
Dp = d1 + d2 + d3 + . Dn . (1) where d1, d2, d3 etc. denote demand by the
individual households 1, 2, 3 etc. This method has certain limitations. It can be used
successfully only in case of those products whose consumers are concentrated in a certain
 Business Economics

region or locality. In case of a widely dispersed market, this method may not be physically
possible or may prove very costly in terms of both money and time. Besides, the demand
forecast through this method may not be reliable for many reasons :
(i) consumers themselves may not be knowing their actual demand in future and hence may
be unable or not willing to answer the query;
(ii) even if they answer, their answer to hypothetical questions may be only hypothetical, not
real; and
(iii) their plans may change with the change in factors not included in the questionnaire.

Sample Survey Method :

Under this method, only a few potential consumers and users selected from the relevant
market through a sampling method are surveyed. Method of survey may be direct interview
or mailed questionnaire to the sample consumers. On the basis of the information obtained,
the probable demand may be estimated through the following formula :
Dp ------
were Dp = probable demand forecast; H = census number of households from the relevant
market; Hs = number of households surveyed or sample households; HR = number of
households reporting demand for the product; Ac = average expected consumption by the
reporting households (=total quantity reported to be consumed by the reporting households
number of households). This method is simpler, less costly, and less time-consuming than the
comprehensive survey method. This method is generally used to estimate short-term demand
from business firms, government departments and agencies, and also by the households who
plan their future purchase. Sample survey method is widely used to forecast demand. This
method, however, has some limitations. The forecaster therefore should not attribute
reliability to the forecast more than warranted. Besides, sample survey method can be used to
verify the demand forecast made by using quantitative or statistical methods. Although some
authors suggest that this method should be used to supplement the quantitative method for
forecasting rather than to replace it, this method can be gainfully used where market area is
localized.

Expert-Opinion Method :
It is one of the most widely used and influential forecasting technique where the opinions and
intuition of management is utilised. The process brings together in an organised manner,
personal judgments about the process being analysed Main reliance is on human judgments.
In this method, the executive uses his own anticipation and what he hears from others.
Outside experts are also consulted and the other executive heads are also required to give
their opinion in the matter. Salesmen are to provide information about customers attitude and
preferences and the activities of competitors. Thus all possible information from the opinions
of various persons is combined together to change the subjective opinions into quantitative
forecasts. No doubt experts and experienced managers can be useful as guides and serve
as reliable source of information, but one has to make his own decision from all the opinions.
Thus in this method broad guess is made by the executive in charge of a business. There are
many advantages and disadvantages of opinion technique of forecasting :

Delphi Method :

Delhpi method of demand forecasting is an extension of the simple expert opinion poll
method. This method is used to consolidate the divergent expert opinions and to arrive at a
compromise estimate of future demand. The Process is simple.
 Business Economics

Under Delphi method, the experts are provided information on estimates of forecasts of other
experts along with the underlying assumptions. The experts may revise estimates in the light
of forecasts made by other experts. The consensus of experts about the forecasts constitutes
the final-forecast. It may be noted that the empirical studies conducted in the USA have
shown that unstructured opinions of the experts is most widely uses technique of forecast.
This may appear a bit, unusual in as much as this gives the impression that sophisticated
techniques, e.g., simultaneous equations model and statistical methods, are not the techniques
which are used most often. However, the unstructed opinions of the experts may conceal the
fact that information used by experts in expressing their forecasts may be based on
sophisticated techniques. The Delphi technique can be used for cross-checking the
information on forecasts.

Market Studies and Experiments :

An alternative method of collecting necessary information regarding demand is to carry out
market studies and experiments in consumers behaviour under actual, though controlled,
market conditions. This method is known in common parlance as market experiment method.
Under this method, firms first select some areas of the representative markets - three or four
cities having similar features, viz., population, income levels, cultural and social background,
occupational distribution, choices and preferences of consumers. Then, they carry out market
experiments by changing prices, advertisement expenditure, and other controllable variables
in the demand function under the assumption that other things remain the same. The
controlled variables may be changed over time either simultaneously in all the markets or in
the selected markets. After such changes are introduced in the market, the consequent
changes in the demand over a period of time (a week, a fortnight, or month) are recorded. On
the basis of data collected, elasticity coefficients are computed. These coefficients are then
used along, with the variables of demand function to assess the demand for the product.
Alternatively, market experiments can be replaced by consumer clinic or controlled
laboratory experiment. Under this method, consumers are given some money to buy in a
stipulated store goods with varying prices, packages, displays, etc. The experiment reveals
the consumers responsiveness to the changes made in prices, packages and displays, etc.
Thus, the laboratory experiments also yield the same information as the field market
experiments. But the former has an advantage over the latter because of greater control over
extraneous factors and its somewhat lower cost.

Limitations : The market experiment methods have certain serious limitations and
disadvantages which reduce the reliability of the method considerably.
(i) The experiment methods are very expensive. It cannot be afforded by small
firms.
(ii) Being a costly affair, experiments are usually carried out on a scale too small permit
generalization with a high degree of reliability.
(iii) These methods are based on short-term and controlled conditions which may not exist in
an uncontrolled market. Hence the results may not be applicable in the uncontrollable long-
term conditions of the market.
(iv) The changes in socio-economic conditions taking place during the field experiments,
such as local strikes or lay-offs, advertising program by competitors, political changes,
natural calamities, may invalidate the results.
(v) Tinkering with price increases may cause a permanent loss of customers to competitive
brands that might have been tried. Despite these limitations, however, market experiment
method is often used to provide an alternative estimate of demand, and also as a check on
 Business Economics

results obtained from statistical studies. Besides, this method generates elasticity coefficients
which are necessary for statistical analysis of demand relationships.

Statistical Methods :
Basically all statistical approaches of forecasting, project historical information into the
future. These are based on the assumption that future patterns tend to be extensions of past
ones and that one can make useful predictions by studying the past behaviour i.e. the factors
which were responsible in the past will also be operative to the same extent in future.
Some companies have detailed sales record item wise as well as territory wise. These sales
record can be utilised to make useful predictions. The information should be complete with
respect to events, policies, quality of the product etc. from period to period. Such information
in general is known as Time series data. The time series for any phenomenon is composed of
three components (i) Trend (ii) Seasonal variation and (iii) Random fluctuations. Trend
exhibits the general tendency of the data and is known as long period or secular trend. This
can be either upward or downward, depending on the behaviour.
Mostly trend is used for forecasting in practice. There are many methods to determine trend.
Some of the methods are :
(i) Graphical method.
(ii) Least square method.
(iii) Moving average method.

(i) Graphical Method : In this method the period is taken on X-axis and the
corresponding sales values on y-axis and the points are plotted for given data
on graph paper. Then a free hand curve passing through most of the plotted
points is drawn. This curve can be used to forecast the values for future. The
method is explained by the following example.
Example 1 : The demand for a product is continually diminishing. Estimate the
demand for 2004 with the help of following information:
Year 1995 1996 1997 1998 1999 2000 2001
Demand
(in 1000 units) 75 70 72 69 50 54 37
Solution : Plot a graph, for the given data to find the demand for 2004 (see fig. 1).
From the graph the demand for 1004 comes out to be approximately 20,000 units.
It is an approximate method as the shape of the curve mainly depends on the choice of
scale for the graph and the individual who draws the free hand curve.

(13) Explain the law of supply?

A microeconomic law that states, all other factors being equal, as the price of a good or
service increases, the quantity of goods or services that suppliers offer will increase, and vice
versa. The law of supply says that as the price of an item goes up, suppliers will attempt to
maximize their profits by increasing the quantity offered for sale.

BREAKING DOWN 'Law Of Supply'

 Business Economics

The chart below depicts the law of supply using a supply curve, which is always upward
sloping. A, B and C are points on the supply curve. Each point on the curve reflects a direct
correlation between quantity supplied (Q) and price (P). So, at point A, the quantity supplied
will be Q1 and the price will be P1, and so on.

The law of supply is so intuitive that you may not even be aware of all the examples around
you.

-When college students learn computer engineering jobs pay more than English professor
jobs, the supply of students with majors in computer engineering will increase.

-When consumers start paying more for cupcakes than for donuts, bakeries will increase their
output of cupcakes and reduce their output of donuts in order to increase their profits.

-When your employer pays time and a half for overtime, the number of hours you are willing
to supply for work increases.

The law of supply summarizes the effect price changes have on producer behavior. For
example, a business will make more video game systems if the price of those systems
increases. The opposite is true if the price of video game systems decreases. The company
might supply 1,000,000 systems if the price is $200 each, but if the price increases to $300,
they might supply 1,500,000 systems.

The law of supply is one of the most fundamental concepts in economics. It works with the
law of demand to explain how market economies allocate resources and determine the prices
of goods and services.

(14) Explain the law of various propositions?

Law of variable proportions occupies an important place in economic theory. This law
examines the production function with one factor variable, keeping the quantities of other
 Business Economics

factors fixed. In other words, it refers to the input-output relation when output is increased by
varying the quantity of one input.

When the quantity of one factor is varied, keeping the quantity of other factors constant, the
proportion between the variable factor and the fixed factor is altered; the ratio of employment
of the variable factor to that of the fixed factor goes on increasing as the quantity of the
variable factor is increased.

Since under this law we study the effects on output of variation in factor proportions, this is
also known as the law of variable proportions. Thus law of variable proportions is the new
name for the famous Law of Diminishing Returns of classical economics. This law has
played a vital role in the history of economic thought and occupies an equally important place
in modern economic theory. This law has been supported by the empirical evidence about the
real world.

Assumptions of the Law:

The law of variable proportions or diminishing returns, as stated above, holds good under the
following conditions:

1. First, the state of technology is assumed to be given and unchanged. If there is

improvement in the technology, then marginal and average products may rise instead of
diminishing.

2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways
by which we can alter the factor proportions and know its effect on output. This law does not
apply in case all factors are proportionately varied. Behaviour of output as a result of the
variation in all inputs is discussed under returns to scale.

3. Thirdly the law is based upon the possibility of varying the proportions in which the
various factors can be combined to produce a product. The law does not apply to those cases
where the factors must be used in fixed proportions to yield a product.

When the various factors are required to be used in rigidly fixed proportions, then the
increase in one factor would not lead to any increase in output, that is, the marginal product
of the factor will then be zero and not diminishing. It may, however, be pointed out that
products requiring fixed proportions of factors are quiet uncommon. Thus, the law of variable
proportion applies to most of the cases of production in the real world.

The law of variable proportions is illustrated in Table 16.1.and Fig. 16.3. We shall first
explain it by considering Table 16.1. Assume that there is a given fixed amount of land, with
which more units of the variable factor labour, is used to produce agricultural output.
 Business Economics

With a given fixed quantity of land, as a farmer raises employment of labour from one unit to
7 units, the total product increases from 80 quintals to 504 quintals of wheat. Beyond the
employment of 8 units of labour, total product diminishes. It is worth noting that up to the use
of 3 units of labour, total product increases at an increasing rate.

This fact is clearly revealed from column 3 which shows successive marginal products of
labour as extra units of labour are used. Marginal product of labour, it may be recalled, is the
increment in total output due to the use of an extra unit of labour.

It will be seen from Col. 3 of Table 16.1, that the marginal product of labour initially rises
and beyond the use of three units of labour, it starts diminishing. Thus when 3 units of labour
are employed, marginal product of labour is 100 and with the use of 4th and 5th units of
labour marginal product of labour falls to 98 and 62 respectively.

Beyond the use of eight units of labour, total product diminishes and therefore marginal
product of labour becomes negative. As regards average product of labour, it rises upto the
use of fourth unit of labour and beyond that it is falling throughout.

Three Stages of the Law of Variable Proportions:

The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the other can be divided into three distinct stages. In order to understand these
three stages it is better to graphically illustrate the production function with one factor
variable.

This has been done in Fig. 16.3. In this figure, on the X-axis the quantity of the variable
factor is measured and on the F-axis the total product, average product and marginal product
are measured. How the total product, average product and marginal product a variable factor
change as a result of the increase in its quantity, that is, by increasing the quantity of one
factor to a fixed quantity of the others will be seen from Fig. 16.3.
 Business Economics

In the top Danel of this figure, the

total product curve TP of variable factor goes on increasing to a point and alter that it starts
declining. In the bottom pane- average and marginal product curves of labour also rise and
then decline; marginal product curve starts declining earlier than the average product curve.

The behaviour of these total, average and marginal products of the variable factor as a
result of the increase in its amount is generally divided into three stages which are
explained below:

Stage 1:

In this stage, total product curve TP increases at an increasing rate up to a point. In Fig. 16.3.
from the origin to the point F, slope of the total product curve TP is increasing, that is, up to
the point F, the total product increases at an increasing rate (the total product curve TP is
concave upward upto the point F), which means that the marginal product MP of the variable
factor is rising.

From the point F onwards during the stage 1, the total product curve goes on rising but its
slope is declining which means that from point F onwards the total product increases at a
 Business Economics

diminishing rate (total product curve TP is concave down-ward), i.e., marginal product falls
but is positive.

The point F where the total product stops increasing at an increasing rate and starts increasing
at the diminishing rate is called the point of inflection. Vertically corresponding to this point
of inflection marginal product is maximum, after which it starts diminishing.

Thus, marginal product of the variable factor starts diminishing beyond OL amount of the
variable factor. That is, law of diminishing returns starts operating in stage 1 from point D on
the MP curve or from OL amount of the variable factor used.

This first stage ends where the average product curve AP reaches its highest point, that is,
point S on AP curve or CW amount of the variable factor used. During stage 1, when
marginal product of the variable factor is falling it still exceeds its average product and so
continues to cause the average product curve to rise.

Thus, during stage 1, whereas marginal product curve of a variable factor rises in a part and
then falls, the average product curve rises throughout. In the first stage, the quantity of the
fixed factor is too much relative to the quantity of the variable factor so that if some of the
fixed factor is withdrawn, the total product will increase. Thus, in the first stage marginal
product of the fixed factor is negative.

Stage 2:

In stage 2, the total product continues to increase at a diminishing rate until it reaches its
maximum point H where the second stage ends. In this stage both the marginal product and
the average product of the variable factor are diminishing but remain positive.

At the end of the second stage, that is, at point M marginal product of the variable factor is
zero (corresponding to the highest point H of the total product curve TP). Stage 2 is very
crucial and important because as will be explained below the firm will seek to produce in its
range.

Stage 3: Stage of Negative Returns:

In stage 3 with the increase in the variable factor the total product declines and therefore the
total product curve TP slopes downward. As a result, marginal product of the variable factor
is negative and the marginal product curve MP goes below the X-axis. In this stage the
variable factor is too much relative to the fixed factor. This stage is called the stage of
negative returns, since the marginal product of the variable factor is negative during this
stage.

It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed
factor is too much relative to the variable factor. Therefore, in stage 1, marginal product of
the fixed factor is negative. On the other hand, in stage 3 the variable factor is too much
relative to the fixed factor. Therefore, in stage 3, the marginal product of the variable factor is
negative.

The Stage of Operation:

 Business Economics

Now, an important question is in which stage a rational producer will seek to produce. A
rational producer will never choose to produce in stage 3 where marginal product of the
variable factor is negative. Marginal product of the variable factor being negative in stage 3, a
producer can always increase his output by reducing the amount of the variable factor.

It is thus clear that a rational producer will never be producing in stage 3. Even if the variable
factor is free, the rational producer will stop at the end of the second stage where the marginal
product of the variable factor is zero.

At the end point M of the second stage where the marginal product of the variable factor is
zero, the producer will be maximising the total product and will thus be making maximum
use of the variable factor. A rational producer will also not choose to produce in stage 1
where the marginal product of the fixed factor is negative.

A producer producing in stage 1 means that he will not be making the best use of the fixed
factor and further that he will not be utilising fully the opportunities of increasing production
by increasing quantity of the variable factor whose average product continues to rise
throughout the stage 1. Thus, a rational entrepreneur will not stop in stage 1 but will expand
further.

Even if the fixed factor is free (i.e., costs nothing), the rational entrepreneur will stop only at
the end of stage 1 (i.e., at point N) where the average product of the variable factor is
maximum. At the end point N of stage 1, the producer they will be making maximum use of
the fixed factor.

It is thus clear from above that the rational producer will never be found producing in stage 1
and stage 3. Stage 1 and 3 may, therefore, be called stages of economic absurdity or
economic non-sense. The stages 1 and 3 represent non-economic regions in production
function.

A rational producer will always seek to produce in stage 2 where both the marginal product
and average product of the variable factor are diminishing. At which particular point in this
stage, the producer will decide to produce depends upon the prices of factors. The stage 2
represents the range of rational production decisions.

We have seen above how output varies as the factor proportions are altered at any given
moment. We have also noticed that this input-output relation can be divided into three stages.
Now, the question arises as to what causes increasing marginal returns to the variable factor
in the beginning, diminishing marginal returns later and negative marginal returns to the
variable factor ultimately.

(15) Define classified for explain economics of large scale production?

A firm has to expand the scale of output in order to achieve its objectives like minimization
of cost, efficient use of resources etc. Economies of scale are the cost advantages that a
 Business Economics

business can exploit by expanding their scale of production. The effect of economies of scale
is to reduce the average or per unit costs of production.

When more units of a good or a service can be produced on a larger scale, with less input
costs per unit of output produced, economies of scale (ES) are said to be achieved.
Alternatively, this means that as a company grows and production units increase, a company
will have a better chance to decrease its costs. Extending this logic to macro level we can say
that, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to
achieve a larger return on production. Through these two techniques, employees would not
only be able to concentrate on a specific task, but with time, improve the skills necessary to
perform their jobs. The tasks could then be performed better and faster. Hence, through such
efficiency, time and money could be saved while production levels increased. Alfred
Marshall made a distinction between internal and external economies of scale.

Just like there are economies of scale, diseconomies of scale (DS) also exist. This occurs
when production is less than in proportion to inputs. What this means is that there are
inefficiencies within the firm or industry resulting in rising average costs.

Economies of Scale

Economies of scale (ES) are the cost advantages that a business can exploit by expanding
their scale of production. The effect of economies of scale is to reduce the average (unit)
costs of production.

When more units of a good or a service can be produced on a larger scale, yet with (on
average) less input costs, economies of scale are said to be achieved. Alternatively, this
means that as a company grows and production units increase, a company will have a better
chance to decrease its costs. Consider the following questions: Why is that we can now buy
a high-performance laptop for just a few thousand Rupees when a similar computer might
have cost you over a lakh of Rupees over some years ago? Why is the average price of
mobile phones falling all the time whilst the functions and performance level are always on
the rise? How can you transfer money from one account to another in a few seconds which
was impossible at low cost in the past? The answer is economies of scale. Scale economies
have brought down the unit costs of production and have fed through to lower prices for
consumers. Economies of scale are a key advantage for a business that is able to grow. Most
firms find that, as their production output increases, they can achieve lower costs per unit.
Economies of scale are the cost advantages that a business can exploit by expanding their
scale of production. The effect of economies of scale is to reduce the average (unit) costs of
production. The economies of large scale production are classified by Marshall into

1. Internal Economies, and 2. External Economies

Internal Economies of Scale

Internal economies of scale are those economies which are internal to the firm. These arise
within the firm as a result of increasing the scale of output of the firm. A firm secures these
economies from the growth of the firm independently. The main internal economies are
grouped under the following heads:
 Business Economics

(i) Technical Economies: When production is carried on a large scale, a firm can afford to
install up to date and costly machinery and can have its own repairing arrangements. As the
cost of machinery will be spread over a very large volume of output, the cost of production
per unit will therefore, be low.

A large establishment can utilize its by products. This will further enable the firm to lower
the price per unit of the main product. A large firm can also secure the services of
experienced entrepreneurs and workers which a small firm cannot afford. In a large
establishment there is much scope for specialization of work, so the division of labor can be
easily secured.

(ii) Managerial Economies: When production is carried on a large scale, the task of manager
can be split up into different departments and each department can be placed under the
supervision of a specialist of that branch. The difficult task can be taken up by the
entrepreneur himself. Due to these functional specializations, the total return can be increased
at a lower cost.

(iii) Marketing Economies: Marketing economies refer to those economies which a firm can
secure from the purchase or sale of the commodities. A large establishment is in a better
position to buy the raw material at a cheaper rate because it can buy those commodities on a
large scale. At the time of selling the produced goods, the firm can secure better rates by
effectively advertising in the newspapers, journals and radio, etc.

(iv) Financial Economies: Financial economies arise from the fact that a big establishment
can raise loans at a lower rate of interest than a small establishment which enjoys little
reputation in the capital market.

(v) Risk Bearing Economies: A big firm can undertake risk bearing economies by spreading
the risk. In certain cases the risk is eliminated altogether. A big establishment produces a
variety of goods in order to cater the needs of different tastes of people. If the demand for a
certain type of commodities slackens, it is counter balanced by the increase in demand of the
other type of commodities produced by the firm.

(vi) Economies of Scale: As a firm grows in size, it is-possible for it to reduce its cost. The
reduction in costs, as a result of increasing production is called economies of scale. The
economies of scale are obtained by the firm up to the lowest point on the firms long run
average cost curve.

Internal Diseconomies of Scale

The extensive use of machinery, division of labor, increased specialization and larger plant
size etc., no doubt entail lower cost per unit of output but the fall in cost per unit is up to a
certain limit. As the firm goes beyond the optimum size, the efficiency of the firm begins to
decline. The average cost of production begins to rise.

The main factors causing diseconomies of scale and eventually leading to higher per unit cost
are as follows:

(i) Lack of co-ordination. As a firm becomes large scale producer, it faces difficulty in
coordinating the various departments of production. The lack of co-ordination in the
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production, planning, marketing personnel, account, etc., lowers efficiency of the factors of
production. The average cost of production begins to rise.

(ii) Loose control. As the size of plant increases, the management loses control over the
productive activities. The misuse of delegation of authority, the red tape brings diseconomies
and leads to higher average cost of production.

(iii) Lack of proper communication. The lack of proper communication between top
management and the supervisory staff and little feedback from subordinate staff causes
diseconomies of scale and results in the average cost to go up.

(iv) Lack of identification. In a large organizational structure, there is no close liaison

between the top management and the thousands of workers employed in the firm. The lack of
identification of interest with the firm results in the per unit cost to go up.

X2

External Economies of Scale:

External economies of scale are those economies which are not specially availed of by .any
firm. Rather these accrue to all the firms in an industry as the industry expands. External
economies of scale can also be realized from the above-mentioned inputs as a result of the
company's geographical location. Thus all fast food chains located in the same area of a
certain city could benefit from lower transportation costs and a skilled labor force. Moreover,
support industries may then begin to develop, such as dedicated fast food potato and/or cattle
breeding farms.

External economies of scale can also be reaped if the industry lessens the burdens of costly
inputs, by sharing technology or managerial expertise, for example. This spillover effect can
lead to the creation of standards within an industry.

The main external economies are as under:

(i) Economies of localization. When an industry is concentrated in a particular area, all the
firms situated in that locality avail of some common economies such as (a) skilled labor, (b)
transportation facilities (c) post and telegraph facilities, (d) banking and insurance facilities
etc.

(ii) Economies of vertical disintegration. The vertical disintegration implies the splitting up
the production process in such a manner that some Job are assigned to specialized firms. For
example, when an industry expands, the repair work of the various parts of the machinery is
taken up by the various firms specialists in repairs.

(iii) Economies of information - As the industry expands it can set up research institutes. The
research institutes provide market information, technical information etc for the benefit of alt
the firms in the industry.

(iv) Economies of byproducts - All the firms can lower the costs of production by making use
of waste materials.
 Business Economics

External Diseconomies: A firm or an industry cannot avail of economies for an indefinite

period of time. With the expansion and growth of an industry, certain disadvantages also
begin to arise.

The diseconomies of large scale production are

(i) Diseconomies of pollution, (ii) Excessive pressure on transport facilities, (iii) Rise in the
prices of the factors of production, (iv) Scarcity of funds, (v) Marketing problems of the
products, (vi) Increase in risks