Introduction to business economics

• Business Economics, also called Managerial Economics, is the application of economic theory and methodology to business. Business involves decision-making. Decision making means the process of selecting one out of two or more alternative courses of action. The question of choice arises because the basic resources such as capital, land, labour and management are limited and can be employed in alternative uses. The decision-making function thus becomes one of making choice and taking decisions that will provide the most efficient means of attaining a desired end, say, profit maximation.

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Scope of business economics

1.Demand Analysis and Forecasting

•  A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.

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2.Cost and production analysis:

• A firm’s profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of  uncertainty in production and cost calculations. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.

3.Pricing decisions, policies and practices:

• Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting.

4.Profit management:

• Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells 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 likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of Managerial Economics.

 5.Capital management:

•  The problems relating to firm’s capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects.

Method of economics

Methods of Economic Analysis:

• An economic theory derives laws or generalizations through two methods:

(1)Deductive Method and (2) Inductive Method.

• These two ways of deriving economic generalizations are now explained in brief:

(1) Deductive Method of Economic Analysis:

• The deductive method is also named as analytical, abstract or prior method. The deductive method consists in deriving conclusions from general truths, takes few general principles and applies them draw conclusions.
• For instance, if we accept the general proposition that man is entirely motivated by self-interest. In applying the deductive method of economic analysis, we proceed from general to particular.
• The classical and neo-classical school of economists notably, Ricardo, Senior, Cairnes, J.S. Mill, Malthus, Marshall, Pigou, applied the deductive method in their economic investigations.

Steps of Deductive Method:

The main steps involved in deductive logic are as under:

(i) Perception of the problem to be inquired into: In the process of deriving economic generalizations, the analyst must have a clear and precise idea of the problem to be inquired into.

(ii) Defining of terms: The next step in this direction is to define clearly the technical termsused analysis. Further, assumptions made for a theory should also be precise.

(iii) Deducing hypothesis from the assumptions: The third step in deriving generalizations is deducing hypothesis from the assumptions taken.

(iv) Testing of hypothesis: Before establishing laws or generalizations, hypothesis should be verified through direct observations of events in the rear world and through statistical methods. (Their inverse relationship between price and quantity demanded of a good is a well established generalization).

Merits of Deductive Method:

The main merits of deductive method are as under:

(i) This method is near to reality. It is less time consuming and less expensive.

(ii) The use of mathematical techniques in deducing theories of economics brings exactness and clarity in economic analysis.

(iii) There being limited scope of experimentation, the method helps in deriving economic theories.

(iv) The method is simple because it is analytical.

Demerits of Deductive Method:

It is true that deductive method is simple and precise, underlying assumptions are valid.

(i) The deductive method is simple and precise only if the underlying assumptions are valid. More often the assumptions turn out to be based on half truths or have no relation to reality. The conclusions drawn from such assumptions will, therefore, be misleading.

(ii) Professor Learner describes the deductive method as ‘armchair’ analysis. According to him, the premises from which inferences are drawn may not
hold good at all times, and places. As such deductive reasoning is not applicable universally.

(iii) The deductive method is highly abstract. It require; a great deal of care to avoid bad logic or faulty economic reasoning.

• As the deductive method employed by the classical and neo-classical economists led to many facile conclusions due to reliance on imperfect and incorrect assumptions, therefore, under the German Historical School of economists, a sharp reaction began against this method. They advocated a more realistic method for economic analysis known as inductive method.

(2) Inductive Method of Economic Analysis:

• Inductive method which also called empirical method was adopted by the “Historical School of Economists”. It involves the process of reasoning from particular facts to general principle.
• This method derives economic generalizations on the basis of (i) Experimentations (ii) Observations and (iii) Statistical methods.
• In this method, data is collected about a certain economic phenomenon. These are systematically arranged and the general conclusions are drawn from them.
• For example, we observe 200 persons in the market. We find that nearly 195 persons buy from the cheapest shops, Out of the 5 which remains, 4 persons buy local products even at higher rate just to patronize their own products, while the fifth is a fool. From this observation, we can easily draw conclusions that people like to buy from a cheaper shop unless they are guided by patriotism or they are devoid of commonsense.

Steps of Inductive Method:

• The main steps involved in the application of inductive method are:

(i) Observation.

(ii) Formation of hypothesis.

(iii) Generalization.

(iv) Verification.

Merits of Inductive Method:

(i) It is based on facts as such the method is realistic.

(ii) In order to test the economic principles, method makes statistical techniques. The inductive method is, therefore, more reliable.

(iii) Inductive method is dynamic. The changing economic phenomenon are analyzed and on the basis of collected data, conclusions and solutions are drawn from them.

(iv) Induction method also helps in future investigations.

Demerits of Inductive Method:

The main weaknesses of this method are as under:

(i) If conclusions drawn from insufficient data, the generalizations obtained may be faulty.

(ii) The collection of data itself is not an easy task. The sources and methods employed in the collection of data differ from investigator to investigator. The results, therefore, may differ even with the same problem.

(iii) The inductive method is time-consuming and expensive.

Conclusion:

• The above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on any one of them. Modern economists are of the view that both these methods are complimentary. They partners and not rivals. Alfred Marshall has rightly remarked:
• “Inductive and Deductive methods are both needed for scientific thought, as the right and left foot are both needed for walking”.
• We can apply any of them or both as the situation demands.

scarity and choice

• Scarcity means that people want more than is available. Scarcity limits us both as individuals and as a society. 
• Scarcity requires choice. People must choose which of their desires they will satisfy and which they will leave unsatisfied. When we, either as individuals or as a society, choose more of something, scarcity forces us to take less of something else.

The price mechanism

Definition of ‘Price Mechanism’

Definition: Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes therein. It is the buyers and sellers who actually determine the price of a commodity.

Definition: Price mechanism is the outcome of the free play of market forces of demand and supply. However, sometimes the government controls the price mechanism to make commodities affordable for the poor people too. For example, the Government of India recently passed an order to decontrol the prices of diesel and remove it from the jurisdiction of the government. Now the prices will be determined by the demand from consumers and supply from the oil companies.

Demand and supply equlibrium

law of demand:

Definition: The law of demand states that other factors being constant (cetris peribus), price and quantity demand of any good and service are inversely related to each other. When the price of a product increases, the demand for the same product will fall.

Description: Law of demand explains consumer choice behavior when the price changes. In the market, assuming other factors affecting demand being constant, when the price of a good rises, it leads to a fall in the demand of that good. This is the natural consumer choice behavior. This happens because a consumer hesitates to spend more for the good with the fear of going out of cash.

The above diagram shows the demand curve which is downward sloping. Clearly when the price of the commodity increases from price p3 to p2, then its quantity demand comes down from Q3 to Q2 and then to Q3 and vice versa.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up.  The effect of such a price rise is to discourage demand, conserve resources, and spread out their use over time. T

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of ‘smart’ phones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. In terms of the labour market  a rise in the wage rate, which is the price of labour, provides a signal to the unemployed to join the labour market.

rationing effect

signalling effect:

The concept of elasticity and its application

Price Elasticity of Demand:

Elasticity of demand refers to price elasticity of demand. It is the degree of responsiveness of quantity demanded of a commodity due to change in price, other things remaining the same.

Mathematical Expression of Price Elasticity of Demand

The price elasticity of demand is defined as the percentage change in quantity demanded due to certain percentage change in price.

Where, E_P= Price elasticity of demand

q= Original quantity demanded

∆q = Change in quantity demanded

p= Original price

∆p = Change in price

Calculation of Price Elasticity of Demand

Suppose that price of a commodity falls down from Rs.10 to Rs.9 per unit and due to this, quantity demanded of the commodity increased from 100 units to 120 units. What is the price elasticity of demand?

Give that,

p= initial price= Rs.10 q= initial quantity demanded= 100 units

∆p=change in price=Rs. (10-9) = Rs.1

∆q=change in quantity demanded= (120-100) units = 20 units

Now,

The quantity demanded increases by 2% due to fall in price by Rs.1.

types/degrees of elasticity of demand

there are five types of elasticity of demand

1. Perfectly Elastic Demand (E_P = ∞)

In the given figure, price and quantity demanded are measured along the Y-axis and X-axis respectively. The demand curve DD is a horizontal straight line parallel to the X-axis. It shows that negligible change in price causes infinite fall or rise in quantity demanded.

2. Perfectly Inelastic Demand (E_P = 0) 

The demand curve DD is a vertical straight line parallel to the Y-axis. It shows that the demand remains constant whatever may be the change in price. For example: even after the increase in price from OP to OP₂ and fall in price from OP to OP₁, the quantity demanded remains at OM.

3. Relatively Elastic Demand (E_P> 1)

The demand curve DD is more flat, which shows that the demand is elastic. The small fall in price from OP to OP₁ has led to greater increase in demand from OM to OM₁. Likewise, demand decrease more with small increase in price.

4. Relatively Inelastic Demand (E_p< 1 )

For example: when the price falls by 10% and the demand rises by less than 10% (say 5%), then it is the case of inelastic demand. The demand for goods of daily consumption such as rice, salt, kerosene, etc. is said to be inelastic.

The demand curve DD is steeper, which shows that the demand is less elastic. The greater fall in price from OP to OP₁ has led to small increase in demand from OM to OM₁. Likewise, greater increase in price leads to small fall in demand.

5. Unitary Elastic Demand ( E_p = 1)

In such type of demand, 1% change in price leads to exactly 1% change in quantity demanded. This type of demand is an imaginary one as it is rarely applicable in our practical life.

practical application of elasticity of demand

The following points highlight the nine main practical applications of the concept of price elasticity of demand. The uses are: 1. Effects of changes in price upon demand 2. Effects of changes in price on revenue 3. Monopoly pricing 4. Price discrimination 5. Wage bargaining by trade unions 6. Importance in taxation 7. Importance in determining the incidence of taxation and few others.

1. Effects of Changes in Price Upon Demand:

The concept is very useful to study the reactions of the demand for a commodity to the changes in its price. If the demand is elastic, a small change in the price brings about a considerable change in the quantity demanded, but in the case of inelastic demand this consequential change in demand is relatively small. So, the concept is relevant to the decisions relating to business pricing and profits

The production process

• It refers to the provision of goods and services for sale in the market with a view to satisfying human needs and wants.
• Inputs take the form of labour of all types, the required raw materials and sources of energy. All these involve cost outlays.
• Time also plays a very important role in the the­ory of production. We usually draw a distinction between the short run and the long-run.

Managers are required to make four different but interrelated production decisions:

(1) Whether or not to actually produce or to shut down;

(2) How much to produce;

(3) What input combination to use and

(4) What type of technology to use.

Simply put, production involves the transfor­mation of inputs – such as capital equipment, labour, and land – into output of goods or services. In this production process, the manager is concerned with efficiency – technical and economic – in the use of these inputs. And the efficiency goal pro­vides us with some basic rules about the manner in which firms should utilize inputs to produce desir­able goods and services.