Business Economics || Demand analysis || Methods of Measuring Price Elasticity of Demand || Relationship between AR and MR

Business Economics

Business Economics, often known as Managerial Economics, is the combination of economic theory with business operations. Economics includes a variety of conceptual tools such as demand, supply, price, competition, and so on. They put these techniques to use in corporate management. Business economics is sometimes known as applied economics in this context.

As a result, define business economics as the study of the application of economic theory to company management. Thus, business economics sits on the nexus of economics and business management, acting as a link between the two disciplines.

Scope of Business Economics:

1.     Forecasting and Demand Analysis.

2.     Cost Analysis and Production Analysis.

3.     Pricing Decisions, policies, and practices.

4.     Profit Management, and.

5.     Capital Management.

Economic objectives of firms

The main objectives of firms are:

1. Profit maximization

In economics, we usually believe that corporations are concerned with maximising profit.

Increased profit means:

• Increased dividends for shareholders.

• Increased profits can be utilised to fund research and development.

• Increased earnings makes the company less vulnerable to takeover.

• Increased profit allows for increased pay for employees.

2. Sales maximization

Firms frequently want to grow their market share – even if it means sacrificing profit.

This might happen for several reasons, including:

• Increased market share boosts monopolistic power, allowing the business to raise prices and profit in the long run.

• Managers want to work for larger corporations since it provides them with more status and higher pay.

• Increasing market share may drive competitors out of business. For example, the rise of supermarkets has resulted in the death of numerous small businesses. Some businesses may engage in predatory pricing, which entails generating a loss to drive a competitor out of business.

3. Growth maximization

This is analogous to sales maximisation and may entail mergers and acquisitions. With this goal in mind, the company may be ready to accept lower levels of profit to grow in size and achieve a larger market share. More market share boosts a company's monopolistic power and capacity to determine prices.

4. Long run profit maximization

In some circumstances, corporations may forego short-term revenues to improve long-term profitability. Firms, for example, may incur a loss in the near run yet enable better earnings in the long run by investing extensively in additional capacity.

5. Social/environmental concerns

A company may pay more costs to select items that are not harmful to the environment or that have not been tested on animals. Firms may also be interested in local community / philanthropic causes.

• Some businesses may include social/environmental issues into their branding. This can eventually boost revenue as the brand becomes more appealing to customers.

• Some businesses may adopt social/environmental issues only for the sake of doing so – even if it has minimal impact on sales/brand image.

6. Co-operatives

Co-operatives may have very different goals than a regular PLC. A co-operative is managed to optimise the well-being of all stakeholders, particularly employees. Any profits made by the co-operative will be distributed to all members.

Demand analysis

 In economics, demand is defined as "want to support by sufficient purchasing power." It is defined as the quantity of a commodity that a consumer is willing to acquire at a particular price during a specified time. The demand for an item in economics refers to both the desire to obtain the product and the ability to pay for it. Because a corporation cannot survive if demand estimates or forecasts are incorrect, demand analysis is one of the most essential parts of managerial economics and is thoroughly researched.

Types of Demand

Demands can be categorized as follows:

1. Individual demand - This is demand from a single consumer. These demands include those for clothing, shoes, and other such items.

2. Household demand - This type of demand is generated by a household and includes items such as washing machines, refrigerators, and houses.

3. Market demand - Market demand is defined as the aggregate demand of all individuals and families in the market.

Some other types of demands are:

1. Direct demand - This type of demand directly meets human desires. Food and clothing are two examples of this desire.

2. Indirect demand - This type of demand is employed to manufacture consumer products. This category includes goods for manufacturing. Derived demand is another name for it.

3. Joint demand — When more than one commodity is required to meet a single requirement, this type of demand is referred to as joint demand. Tea leaves, sugar, and milk, for example, are all necessary to satisfy the single demand for tea.

4. Composite demand — This type of need may satisfy many desires at the same time. This type of demand includes electricity, which serves the demands of several houses.

Factors in Creating Demand and Demand Analysis

A product's or service's demand is influenced by a variety of variables.

These elements are as follows:

1. The commodity's price

2. The end user's income

3. The cost of alternative and complementary items

4. Predictions concerning the product's future pricing

5. Advertisements

6. Fiscal policies

7. Other elements, such as traditions, customs, seasons, social issues, and others, all have an impact on product demand.

Demand analysis formula – Demand Function

The demand function is a mathematical connection between the amount desired and the determinants of the commodity.

It can be represented as

Q = f (Demand determinant)

Where Q = quantity demanded of a commodity

Demand functions are generally of two kinds. 

They are:

1. Individual demand function - the mathematical link between an individual consumer's demand and the factors of individual demand.

2. Market or aggregate demand function - this is the mathematical link between market demand for a commodity and market demand determinants.

Law of Demand

Alfred Marshall proposed the Law of Demand, which defines a consumer's behaviour in requesting a commodity in response to price fluctuations. Other things being equal, the law asserts that the higher the price of the product, the lower the demand, and the lower the price, the larger the amount desired.

In other words, while all other variables stay constant, demand for a product changes inversely with price.

The conventional law of demand is given by the following formulae: Qx = f (Px)

Where Qx= Quantity demanded of commodity x Px= Price of the commodity x

Because of changes in substitution impact and consumer income, the Law of Demand is typically operative.

As we can see, the demand curve slopes downwards from left to right.

This is due to the following effects:

1.       The Law of Diminishing Marginal Utility — According to this law, when a customer purchases more and more units of a commodity, its utility to him diminishes. Thus, to achieve maximum happiness, the buyer purchases a commodity whose marginal utility equals the product's price. As a result, he buys more units when the price is low and fewer units when the price is high.

2.       Income impact — It is a well-known fact that a price decline boosts customers' purchasing power and vice versa. This is known as the income impact.

3.       The substitution effect - occurs when the price of a thing lowers but the price of its alternatives remains constant, causing the customer to purchase more of the product.

The rule of demand, like everything else, includes exceptions.

These are listed below:

1.     Expectations about future price

2.     Veblen effect or commodity with snob appeal

3.     Giffen products

4.     Consumer’s psychological bias

Methods of Measuring Price Elasticity of Demand

There are four fundamental methods for calculating the price elasticity of demand.

These are the techniques.

1.     Percentage Method

One of the most frequent techniques to assess price elasticity of demand is the percentage method, which measures price elasticity in terms of the rate of percentage change in the quantity requested to the percentage change in price.

Price elasticity of demand may be represented numerically using this way as 

As an illustration: When a commodity's price was Rs 10 per unit, the market demand was 50 units per day. When the commodity's price dropped to Rs 8, demand increased to 60 units.

The price elasticity of demand may be computed as follows:

Price elasticity of demand, unlike price elasticity of supply, is always negative since quantity demanded and price of the commodity has an inverse connection. This indicates that the higher the price, the lower the demand, and the lower the price, the larger the demand for the product.

1.     Total Outlay Method

Professor Alfred Marshall created the whole outlay approach, often known as the total spending method, for determining the price elasticity of demand. Price elasticity of demand may be estimated using this approach by comparing total expenditure on a commodity before and after the price change.

When we compare the costs, we may receive one of three results.

They are

Ø  Elasticity of demand will be greater than unity (Ep > 1)

When total spending rises with falling prices and falls with rising prices, the value of PED is larger than one. In this case, price increases and total outlay or expenditure go in opposing directions.

As an illustration: When a commodity's price was Rs 10 per unit, the market demand was 50 units per day. When the commodity's price dropped to Rs 8, demand increased to 60 units.

The price elasticity of demand may be computed as follows:

Price elasticity of demand, unlike price elasticity of supply, is always negative since quantity demanded and price of the commodity has an inverse connection. This indicates that the higher the price, the lower the demand, and the lower the price, the larger the demand for the product.

Ø  The elasticity of demand will be equal to unity (Ep = 1)

When total commodity spending remains constant in response to a change in commodity price, the value of PED equals one.

Ø  Elasticity of demand will be less than unity (Ep < 1)

When total spending reduces when prices fall and increases as prices rise, the value of PED is less than one. In this case, the commodity price and total outlay both move in the same direction.

1. Point Method

Prof. Alfred Marshall also developed the point method for gauging the price elasticity of demand. This approach is used to calculate the price elasticity of demand at any point along the curve.

The elasticity of demand will be different at each point on a demand curve, according to this technique. As a result, this strategy is used when there is a slight change in the commodity's price and quantity requested.

This approach expresses price elasticity of demand (PED) numerically as

The technique of computing PED, on the other hand, is determined by the nature of the demand curve.

These approaches are described further below.

Price elasticity on a linear demand curve

If the demand curve is linear, PED is easily determined by using the above calculation, i.e.

MN is a linear demand curve in the illustration, and P is the curve's midpoint.

As a result, at point P,

Price elasticity on a non-linear demand curve

If the demand curve is non-linear or convex, a tangent line is created through the point where the PED is to be measured. The PED is then computed once again as DD is a non-linear demand curve in the diagram. If P is the location at which we wish to test price elasticity, we must first draw a tangent through it. Tangent MN has therefore been drawn through point P. PED can now be quantified.

4. Arc Method

An arc is formed by any two points on a demand curve, and the coefficient of price elasticity of demand of an arc is known as arc elasticity of demand. This approach is used to determine the price elasticity of demand across a given price and quantity range. Thus, when the price or quantity requested of a product is highly altered, this approach is used to calculate PED. Elasticity is assessed by taking mean values of price and quantity wanted in the arc method. The price and quantity requested average is computed as

Relationship between AR and MR

The link between AR and MR is determined by whether the price remains constant or declines as output increases. However, if nothing is said about the type of price increases with output increases, then the following general relationship exists between AR and MR:

1. AR rises as long as MR exceeds AR (or when MR exceeds AR, AR rises).

2. When MR equals AR, AR is maximum and constant (or when MR = AR, AR is maximum).

3. AR declines when MR is less than AR (or when MR AR).

 It should be emphasised that the specific connection between AR and MR is determined by the price-output relationship, that is, whether the price remains constant or varies inversely with production. 

CONSUMER BEHAVIOR

Concept of Utility:

Jevon (1835-1882) is the first economist to bring the notion of utility into economics. "Utility is the foundation upon which an individual's demand for a commodity is based," he says.

The utility of a product or service is described as "the ability of a commodity or service to fulfil human needs."

Cardinal Utility Analysis Assumptions:

The following are the major assumptions or premises on which the cardinal utility analysis is based.

(i)       Rationality

(ii)     The utility is cardinally measurable

(iii)    Money's marginal utility remains constant

(iv)   Decreasing marginal utility

(v)     Independent utilities

(vi)   Method of introspection

Criticism:

The notion of cardinal utility was harshly attacked by Pareto, an Italian economist. According to him, usefulness is neither quantitative nor addible. It is, nonetheless, comparable. He proposed that the idea of utility be replaced with a preference scale. Following in the footsteps of Pareto, Hicks and Allen developed the technique of indifference curves. As a result, the cardinal utility method is replaced by the ordinal utility function.

INDIFFERENCE CURVE ANALYSIS

What is an Indifference Curve?

It is a curve that displays all of the product combinations that provide the same level of happiness to the consumer. Because all of the combinations provide the same level of happiness, the buyer prefers them all equally. As a result, the curve is known as the Indifference Curve.

Indifference Map

A collection of Indifference Curves constitutes an Indifference Map. It provides a comprehensive picture of a consumer's preferences.

The figure below depicts an indifference map made up of three curves:

Ø We know that a customer is agnostic about the combinations that are on the same indifference curve. It is worth noting, however, that he favours combinations on the higher indifference curves to those on the lower ones.

Ø This is since a greater indifference curve indicates a higher degree of contentment. As a result, all combinations on IC1 provide the same level of satisfaction, whereas all combinations on IC2 provide higher levels of satisfaction than those on IC1.

Marginal Rate of Substitution

The Marginal Rate of Substitution is the rate at which a customer is prepared to forego some units of good X in exchange for one additional unit of good Y at the same utility. The indifference curve is analysed using the Marginal Rate of Substitution.

Properties of an Indifference Curve or IC

Ø IC slopes downhill to the right;

Ø An IC is always convex to the origin;  

Ø Indifference curves never intersect; and

Ø Two ICs will never intersect.

Ø They also do not have to be parallel to each other.

Take a look at the diagram below:

The figure depicts two ICs crossing at location A. Because A and B are both on IC1, they provide the same amount of enjoyment. Similarly, A and C provide the same amount of enjoyment since they are on IC2. As a result, we might conclude that B and C provide the same amount of enjoyment, which is logically nonsensical. As a result, no two ICs can contact or intersect with one other.

Ø When opposed to a lower IC, a greater IC suggests a higher degree of contentment.

Ø A greater IC indicates that a buyer prefers more things than not.

Ø An IC does not come into contact with the axis.

Budget Line

Because a higher indifference curve signifies a better degree of contentment, a buyer will strive for the highest IC feasible to optimise his satisfaction.

To achieve so, he must purchase additional products and operate under the following two constraints:

1. He must pay the purchase price and

2. He has a restricted salary, which limits his capacity to purchase these items.

Ø As seen above, a budget line depicts all potential combinations of two commodities that a customer may purchase with the finances he has available at the specified pricing of the goods. All of the combinations that are within his financial means are on the budget line.

Ø A point outside the line (point H) denotes a combination that is out of the consumer's financial grasp. A point within the line, on the other hand (point K), shows the consumer's underspending.