Managerial economics and demand analysis
Managerial economics applies economic theory to business decisions. Its core is demand: utility, indifference curves, elasticity and forecasting.
Managerial economics: nature, scope and importance
- Mainly microeconomic: it studies the firm, using macroeconomics (inflation, policy, business cycles) as background.
- Normative and prescriptive: it says what a firm should do, not only what happens.
- Pragmatic: it blends theory with tools from statistics, accounting and operations research.
- Scope: demand analysis and forecasting, cost and production, pricing, profit management, capital budgeting.
- Importance: better decisions under uncertainty and better forward planning.
Cardinal and ordinal utility
The IC approach splits a price effect into a substitution effect and an income effect.
Properties of indifference curves
| Property | Reason |
|---|---|
| Slope downward to the right | More of one good must mean less of the other for equal satisfaction |
| Convex to the origin | Diminishing marginal rate of substitution |
| Never intersect | Crossing would give one combination two levels of satisfaction |
| Higher curve, higher satisfaction | It contains more of at least one good |
Elasticity of demand
| Type | Formula | Reading the value |
|---|---|---|
| Price (Ep) | %ΔQ ÷ %ΔP | 0 perfectly inelastic; below 1 inelastic; 1 unitary; above 1 elastic; ∞ perfectly elastic |
| Income (Ey) | %ΔQ ÷ %ΔY | Negative: inferior good. 0 to 1: necessity. Above 1: luxury |
| Cross (Exy) | %ΔQx ÷ %ΔPy | Positive: substitutes. Negative: complements. Zero: unrelated |
| Advertising (promotional) | %ΔQ ÷ %Δ advertising spend | How sales respond to promotion |
Worked example: price elasticity two ways
The price of a snack rises from ₹20 to ₹25 and monthly sales fall from 1,000 to 800 packets. Find price elasticity by the percentage method on initial values and by the arc (midpoint) method.
- Percentage method: %ΔQ = 200 ÷ 1,000 = 20%; %ΔP = 5 ÷ 20 = 25%.
- Ep = 20 ÷ 25 = 0.8 (sign ignored): inelastic on this method.
- Arc method: ΔQ ÷ average Q = 200 ÷ 900 = 0.2222; ΔP ÷ average P = 5 ÷ 22.5 = 0.2222.
- Ep = 0.2222 ÷ 0.2222 = 1.0: unitary.
- Check with total outlay: ₹20 × 1,000 = ₹20,000 and ₹25 × 800 = ₹20,000. Spending is unchanged, which matches unitary elasticity.
0.8 by the initial-value method; 1.0 by the arc method (working rounded to four decimals). NET states the method, so use the one it asks for.
Worked example: income elasticity
A household's monthly income rises from ₹40,000 to ₹50,000, and its demand for good X rises from 10 to 12 units. Find income elasticity on initial values.
- %ΔQ = 2 ÷ 10 = 20%.
- %ΔY = 10,000 ÷ 40,000 = 25%.
- Ey = 20 ÷ 25 = 0.8.
- Check: 0.8 × 25% = 20%.
Ey = 0.8: positive and below 1, so X is a normal good and a necessity.
Exceptions to the law of demand
- Giffen goods: inferior staples whose demand rises with price, because a strong income effect outweighs the substitution effect.
- Veblen goods: prestige goods bought for show (conspicuous consumption).
- Expected further price rises, buyers judging quality by price, and emergencies.
Demand forecasting methods
| Group | Methods |
|---|---|
| Survey (opinion) methods | Consumer survey (complete enumeration, sample, end-use), sales force opinion, expert opinion, Delphi |
| Statistical methods | Trend projection (least squares), moving averages, exponential smoothing, regression and econometric models |
| Barometric method | Leading, coincident and lagging indicators |
| Market experiments | Test marketing in chosen cities; controlled experiments |
NET gives one-line elasticity numericals, asks you to read the sign of income and cross elasticity, tests IC properties in statement form, and asks which forecasting method fits a case.
Typical MCQ: “Price falls and total spending on a good stays the same. What is its price elasticity?” Unitary (Ep = 1), by Marshall's total outlay method. Trap: 'no change in spending' does not mean zero elasticity.
Typical MCQ: “Which elasticity is negative for an inferior good?” Income elasticity. Trap: price elasticity is negative for almost all goods, so its sign does not identify an inferior good.
Typical MCQ: “Petrol prices rise and car sales fall. What is the sign of the cross elasticity?” Negative, because the goods are complements. Trap: substitutes, such as tea and coffee, have a positive cross elasticity.
Read the sign: income negative = inferior; cross positive = substitutes, negative = complements. ICs are D-C-N: Downward, Convex, Never cross.