BUSINESS ECONOMICS

1. BUSINESS ECONOMICS

2. Origin of Business Economics • Business Economics emerged in 1951 with the publication of Managerial Economics by Joel, Dean, to bridge the gap between the theory and practice of economics.

3. What is Economics? • Science of wealth. Some earlier economists defined Economics as follows: “An inquiry into the nature and causes of the wealth of the nations’’ (Adam Smith) • Sciencewhich deals with wealth" (J.B. Say) • Science of material well-being. • "Economics is a study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. (Alfred Marshall).

4. What is Economics Cont’d? • Science of material well-being. • "Economics is a study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. (Alfred Marshall). • Science of choice making. Robbins gave a more scientific definition of Economics. • "Economics is the science which studies human behaviour as a relationship between end and scarce means which have alternative uses".

5. What is Economics cont’d? • Science of dynamic growth and development. • - "Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce various commodities over time and distribute them for consumption now and in the future amongst various people and groups of society. It analyses the costs and benefits of improving the patterns of resource allocation". (Paul A. Samuelson)

6. What is Economics cont’d? • From the above definitions, it is clear that: • an important problem faced by each and every nation of the world is the creation and distribution of wealth • Since the problems of poverty, unemployment etc. can be solved to a greater extent when wealth is produced and is distributed equitably • How to maximise individual welfare • Economics is a science; itstudies economic human behaviour scientifically. It studies how humans try to optimise (maximize or minimize) certain objective under given constraints. • Human ends (wants) are Unlimited • Means (resources) are scarce

7. What is Economics cont’d? • Since resources (natural productive resources, man-made capital goods, consumer goods, money and time etc.) are limited economic problem arises. • Resources have alternative uses • Resources are simply anything used to produce a good or services or, more generally, to achieve a goal. • Making a choice involves a cost, an alternative foregone ( an opportunity cost) • Economic resources - physical, human, financial are not fixed and can be increased by human ingenuity, exploration, exploitation and development. • Economics is the science of making decisions in the presence of scarce resources. • Economics is a science of management of limited resources given unlimited wants of economic agents. It is concerned with the allocation of scarce resources among alternative uses. These are the main issues confronted regularly by business firms

8. What is Business? • The term business refers to a system created to satisfy society’s needs and desires. • It is an organized effort of enterprises to produce or distribute goods and services. • The goods and services are limited and have alternative uses. • These are used to satisfy human wants which are unlimited. • In short, business includes all activities connected with production, trade, banking, insurance, finance, agency, advertising, packaging and other several related activities.

9. What is Business Economics? • Business economics is "the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management". (Spencer and Siegelman) • "Business economics deals with the use of economic modes of thought to analyse business situation" (Mc Nair and Meriam) • The purpose of business economics is show how economic analysis can be used in formulating business policies (Joel Dean) • Business economics is primary concerned with the applicability of economics concepts and analyses to decisions made by businesses (Collberg) • From the above definitions, business economics can be said to be a discipline which deals with the application of economic principles, theory and methodology in the management of business.

10. What is Business Economics? It helps a business manager in: • decision making (i.e. selecting from alternative options/ making informed choices) to achieve the desired results. • planning in advance for the future. For example, demand forecasting, pricing, type of competition envisaged, etc. • analyzing and solving business problems Typically all firms have different departments or units: • (1) production and operations • (2) marketing • (3) finance and accounting and • (4) human resources.

11. What is Business Economics? • An important characteristic of business economics is that it is normative or prescriptive in nature rather than positive or descriptive • It is, therefore, concerned with “what ought to be” rather than “what is” and cannot be neutral about ends. It deals with how decision should be made by the business executives to achieve the goals of the business. • As a normative science, business economics gives suggestions regarding the best possible way to achieve the goals of the firm. It passes value judgments on the actions of the business manager. This involves two aspects: • (1) it tells the aims and objectives a firm or manager should pursue and • (2) it shows how best to achieve these aims in a particular situation.

12. What is Business Economics? • Thus, business economics is concerned with “what should happen” rather than “what does happen”. Instead of explaining what a firm is doing, it explains what a firm should do to make it s decision effective.

13. The Economic Problems and the Firms • The problem of allocation (what to produce and in what quantity?)This is the first concern of every potential business firm. What to produce to satisfy the wants of people? This problem directly arises from the problem of scarcity of resources. • The problem of choice of production method (how to produce?). I.e. what production methods are employed for the production of the various goods and services? • The problem of distribution (to whom to produce?). Who should have how much of what has been produced and by what means should they acquire the good? • The problem of Efficiency (Are the use of productive resources economically efficient? Given that resources are scarce, it is prudent to ensure that resources are put to the most efficient utilization. A firm that is operating efficiently is operating on its production possibility frontier ( this concept is explained in subsequent session)

14. The Economic Problems and the Firms • The problem of full employment of resources. Are resources being fully utilized? This question is important in that it helps to determine whether there exist underutilsation of resources in the firm. • The problem of growth/expansion (is the productive capacity of the firm increasing, declining or remaining static over time?). Growth is important for every economy and also for business firms. If a firm grows, it is able to expand its capacity or scale of production.

15. Production Possibility Frontier Definition • A graph that shows the alternatives production capabilities of an economy or a production unit. • It shows the maximum combination of two goods that a production unit can produce when it utilizes all the available resources, given technology. • As the productive capacities of the firm/economy are limited, a choice must be made among quantities of different goods. This demands a decision on how much resource should beallocated among the different possible goods. for example, how

16. Production Possibility Frontier cont’d Assumptions • There are given amount of productive resources and remain fixed • Resources can be shifted from the production of one commodity to the other • Resources are being used fully and with utmost technical efficiency. i.e. resources are neither unemployed, underemployed nor inefficiently utilized • Technology is constant. i.e. does not undergo changes

17. Production Possibility Frontier cont’d

18. Production Possibility Frontier cont’d Cocoa (Metric Tonnes) A B Gold (Ounces)

19. Illustrating the Basic Economic Questions The problem of scarcity, choice and resource allocation • the limit provided by the possibility curve illustrates scarcity • all the wants of the firm cannot be satisfied because of scarcity • The firm cannot increase the production of both goods • However, different combinations can be produced ( choice) • If the firm can produce more of one product only by reducing the quantity of the other. This means that it has to withdraw resources from the production of one to the other( resource allocation and cost)

20. The problem of Unemployment and under employment • Discuss attainable and unattainable points • Discuss points below the possibility frontier • There will be full employment aggregate demand is large enough to buy the total ouput produced by full employment • Increase in AD leads to increase employment and thereby a reduction in unemployment

21. The problem of growth • The combination of consumer goods ( x-axis) and capital goods( y-axis) • Allocating more resources to capital goods and less for consumer goods. capital accumulation increases the productive capacity of the firm • The principle of increasing opportunity cost • Why opportunity cost increases? Resources are not perfectly substitutable. i.e. not equally efficient in the production of all goods.

22. THE COMPETITIVE MARKET MODEL • For many firms, prices are determined not by them but by the market. • The market dominates a firm’s activities. • The more competitive the market, the greater this domination becomes. • In the extreme case, the firm may have no power at all to change its price • In competitive markets, consumers are price takers • So how does a competitive market work? • For simplicity we will examine the case of a perfectly competitive market • In a competitive market, we have too main forces: the forces of Demand and Supply

23. The structure of the demand and supply model. Households • Who attempt to maximize utility, they face diminishing marginal utility, and are subject to a budget constraint. Firms • Attempt to maximize profits. Firms face cost constraints, and are subject to the law of diminishing returns in production.

24. What is Demand? • it refers to the quantities that people are or would be willing to buy at different prices during a given time period, assuming that other factors affecting these quantities remain the same. This definition incorporates 3 important concepts: • It involves three parameters – price, quantity and time. • It refers to quantities in the plural, therefore a whole relationship, not a single quantity. • It involves the ceteris paribus (other things being equal) assumption, which is a very common one in making statements in economics.

25. Tables, graphs and equations Tables • These are the simplest method of representation. The table shows the general ‘law of demand’, that less is demanded at higher prices. • Tables are not very useful for analytical purposes.

26. Tables, graphs and equations Cont’d Graphs/Demand Curve • These are much more useful for analysis. The demand relationship in this case is both inverse and linear.

27. Tables, graphs and equations Cont’d • the concepts of demand and quantity demanded is illustrated: • the former relates to the whole demand curve whereas the latter relates to a single point on the curve. • it is mainly limited to examining two-variable relationships. • Demand relationships often involve many variables and although the effects of these can be shown on a graph, as seen in subsequent sections, they are difficult to measure.

28. Tables, graphs and equations Cont’d • Equations • These are the most useful method of representation for analytical purposes since they explicitly show the effects of all the variables affecting quantity demanded, in a concise form that at the same time reveals important information regarding the nature of the relationship. • The general form of the demand function in terms of price and quantity demanded is: • This is the most general way of describing the relationship since it does not involve any specific mathematical form

29. Tables, graphs and equations Cont’d • This can be expanded by including any number of variables that might affect quantity demanded on the right hand side of the equation, for example: • A represents advertising expenditure, Y represents average income of the market and Ps represents the price of a substitute product. • In the two-variable case the demand function can be expressed in a linear form: • The coefficients a and b can then be calculated for the demand schedule in Table above

30. Tables, graphs and equations Cont’d • One way of doing this is to use simultaneous equations and substitute any two pairs of values in the table to solve for a and b. • it is more insightful to calculate the value of b first, using the mathematical concept that b represents • Again any two pairs of values can be used to establish that • if the first two pairs of values are taken

31. Interpretation of equations • The value of ‘a’ represents the maximum sales that will occur if the price is zero • ‘b’ represents marginal effect of price on quantity demanded • the value of c represents the marginal effect of Y (income) on Q • Sometimes the demand function may be non-linear such as equation (2.7) this demand function is in the power form As with the linear form, the function can be extended to include other variables; in this case the function is multiplicative

32. The Demand Function • A general equation representing the demand curve Qxd= f(Px,PY , M, H,) • Qxd= quantity demand of good X. • Px= price of good X. • PY = price of a related good Y. • Substitute good. • Complement good. • M = income. • Normal good. • Inferior good. • H = any other variable affecting demand.

33. Inverse Demand Function • Price as a function of quantity demanded. • Example: • Demand Function • Qxd= 10 – 2Px • Inverse Demand Function: • 2Px = 10 – Qxd • Px= 5 – 0.5Qxd

34. Determinants of Demand

35. Price A to B: Increase in quantity demanded 10 6 4 7 Quantity Change in Quantity Demanded A B D0

36. Price 6 D1 D0 Quantity 7 13 Change in Demand D0 to D1: Increase in Demand

37. Consumer Surplus • The demand curve reveals the amount of a product consumers will buy at a given price. • Consumer surplus is the value consumers get from a good but do not have to pay for. • This concept is important to managers because it tells how much extra money consumers would be willing to pay for a given amount of a purchased product. • Geometrically, consumer surplus is the area above the price paid for a good but below the demand curve

38. Price Price 5 Consumer Surplus 4 3 2 P0 1 Qty D 0 D Qty Q0 0 4 5 1 2 3 (a) (b) Consumer Surplus cont’d

39. I got a great deal! • That company offers a lot of bang for the buck! • Dell provides good value. • Total value greatly exceeds total amount paid. • Consumer surplus is large.

40. I got a lousy deal! • That car dealer drives a hard bargain! • I almost decided not to buy it! • They tried to squeeze the very last cent from me! • Total amount paid is close to total value. • Consumer surplus is low.

41. THE THEORY OF INDIVIDUAL BEHAVIOUR

42. Overview Consumer Behaviour • Indifference Curve Analysis. • Consumer Preference Ordering. II. Constraints • The Budget Constraint. • Changes in Income. • Changes in Prices. III. Consumer Equilibrium IV. Indifference Curve Analysis & Demand Curves • Individual Demand. • Market Demand.

43. Consumer Behaviour • Consumer Opportunities • The possible goods and services consumer can afford to consume. • Consumer Preferences • The goods and services consumers actually consume. • Given the choice between 2 bundles of goods a consumer either: • Prefers bundle A to bundle B: A  B. • Prefers bundle B to bundle A: A  B. • Is indifferent between the two: A  B.

44. Indifference Curve Analysis Indifference Curve • A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Marginal Rate of Substitution • The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. Good Y III. II. I. Good X

45. Consumer Preference Ordering Properties • Completeness • More is Better • Diminishing Marginal Rate of Substitution • Transitivity

46. A B C Complete Preferences • Completeness Property • Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!) • If the only bundles available to a consumer are A, B, and C, then the consumer • is indifferent between A and C (they are on the same indifference curve). • will prefer B to A. • will prefer B to C. Good Y III. II. I. Good X

47. 100 33.33 1 3 More Is Better! • More Is Better Property • Bundles that have at least as much of every good and more of some good are preferred to other bundles. • Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X. • Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y. • More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI. Good Y III II I. A B C Good X

48. 100 50 33.33 25 1 2 3 4 Diminishing MRS MRS • The amount of good Y the consumer is willing to give up to maintain the same satisfaction level decreases as more of good X is acquired. • The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. • To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X. • To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X. • To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X. Good Y III. II. I. A B C D Good X

49. 100 75 50 1 7 5 Consistent Bundle Orderings • Transitivity Property • For the three bundles A, B, and C, the transitivity property implies that if C  B and B  A, then C  A. • Transitive preferences along with the more-is-better property imply that • indifference curves will not intersect. • the consumer will not get caught in a perpetual cycle of indecision. Good Y III. II. I. A C B 2 Good X

50. Budget Line Y = M/PY – (PX/PY)X The Budget Constraint • Opportunity Set • The set of consumption bundles that are affordable. • PxX + PyY M. • Budget Line • The bundles of goods that exhaust a consumers income. • PxX + PyY = M. • Market Rate of Substitution • The slope of the budget line • -Px / Py. The Opportunity Set Y M/PY X M/PX