Business Economics

&
Financial Analysis
 General Introduction
Q) Why should an Engineering student study concepts of economics finance and accountancy?

A) Industry today requires competent engineers with managerial and business skills. Why because
the entire economy is liberalized, means, government has dismantled the role of public sector in
economic activities, now doors are opened for the active participation of the private enterprise in the
development of economics enterprises. Even in case of certain industries which were previously
reserved for the public sector, private participation is now allowed. Another important thing is a lot of
financial and non-financial support is coming from government to existing and new entrepreneurs to
run and start new business enterprise. Investment is coming form the other countries also. All these
reasons lead to increased competition. In this highly competitive environment only fittest will survive.
This means, “Survival of the fittest” is the norm of the day.

To become successful, companies are looking for managers who can understand and implement
technology. That is why Indian industry needs competent engineers with business and managerial
skills. Particularly, manages who can drive objective of firm successfully. A proper understanding over
subject matters of economics, finance and accounting will enable an engineer to apply his engineering
skills most effectively and efficiently. This is the need of studying this subject [Managerial
Economics & Financial Analysis] which is the combination of Business and Accountancy.
 UNIT - II
Introduction to Economics
Every science consists of hypothesis, generalizations and theories which explains the behavior
of phenomenon it studies. Economics is no exception to this. Economics studies the behavior of man
and society with regard to use scare resources for achieving maximum possible satisfaction. It also
studies the factors which determine the levels of national income, employment, prices and how
economic growth takes place. It has discovered and established some hypothesis and laws about all
these.

The subject matter of economics has been divided into two parts as under:

1) Micro Economics 2) Macro Economics

Micro Economics: It deals with analysis of small individual units of the economy such as individual
consumer, individual firms and small aggregates or groups of individual units such as various
industries and markets. The whole content of micro economics theory is presented in the following
chart.
Macro Economics: It deals with aggregate of all the quantities of the units of the economy. But it dose
not deal with individual units of the economy. National Income, National output etc., are the subject
matters of Macro Economics. Various aspects of Macro Economics theory are shown in the following
‘chart’

MACRO ECONOMIC THEORY

Theory of Income and Theory of general price Macro theory of

Theory of
employment level and inflation Distribution
economic
growth

Theory of Theory of
Consumption Investment
Function

Theory of Inflation
Or
Business cycles

Another Classification of Economics is as follows :

Positive Economics: It deals with explaining what it is , that is, it describes theories and laws to
explain observed economic phenomenon. In the positive macro economics, we are broadly concerned
with how the level of National Income and employment, aggregate consumption and investment, and
general price levels are determined. But what should be the prices, what should be the saving rate,
what should be the allocation of resources and what should be the distribution of income are not
discussed.

Normative Economics: Normative Economics is concerned with describing what should be thing. It
is, therefore also, called prescriptive economics. What price for a product should be fixed? What wage
rate should be paid? , How income should be distributed? Etc., fall with in the preview of Normative
Economics. Normative Economics involves value judgments or what are simply known as values.

Introduction to Managerial Economics

Managerial Economics means application of economic theory to the problems of
management. It is concerned with the applicability of economic concepts and analysis to decision-
making in business. The prime function of a management executive in a business organization is
decision making and forward planning. Decision- making means the process of selecting one
action form two or more alternative courses of action. Where as forward planning means establishing
plans for future.

The questions of choice arises because resources such as capital, land, labor and management
are limited and can be employed in the alternative uses. Thus, the decision – making function becomes
one of making choices or decisions that will be the most effective means of attaining a desired end,
say, profit maximization. Once a decision is made about the particular goal to be achieved, plans as to
production, pricing, capital, raw material, labor etc., are prepared. Thus, forward planning goes hand in
hand with decision- making.

A Significant characteristics of the conditions in which business organizations work and take
decisions is uncertainty. And this fact of uncertainty not only makes the function of decision-making
and forward planning more complicated but adds different dimensions to it. If the knowledge of the
future were perfect, plans could be formulated without error and hence without any need for
subsequent revision. However, in the real world, the business manages rarely has complete information
and estimates about future predicted as best as possible. As plans are implemented over period of time,
more facts become known, so that in their light, plans may be revised, and a different course of action
adopted. Managers are thus, engaged in a continuous process of decision – making through an
uncertain future and the over all problem confronting them is one of the adjustment to uncertainty.

In fulfilling the function of decision –making in an uncertainty frame work, economic theory
can be applied into service with considerable advantage. Economic theory deals with a number of
concepts and principles relating to profit, demand, cost-pricing, production, competition, business
cycles, national income etc., the way economic analysis can be used towards solving business
problems, constitutes the subject
matter of Managerial Economics.

Significance of Managerial Economics:

Managerial Economics presents those aspects of traditional economics which are relevant for
business decision- making in real life. It also incorporates useful ideas form other disciplines such as
psychology, sociology, Mathematics, Statistics etc., if they are found relevant for decision making.
Managerial economics helps in reaching a variety of business for example:

- What products and services should be produced?

- What inputs and production techniques should be used?
- How much output should be produced and at what prices it should be sold?
- What are the best sizes and locations of new plants?
- How should the available capital be allocated?
- In what project investments should be made? Etc.,

Characteristics of Managerial Economics:

 It is a micro economics in character. This is because the unit of study is a firm. It deals with all the
economic problems of an extra price. But it does not deal with entire economy as a unit of study.
 Managerial Economics largely uses the body of economic concepts and principles which is known
as “Theory of the firm” or “Economics of the firm”. It also seeks to apply profit theory which
forms part of distribution theories in economics.
 Managerial Economics belongs to normative economics and it is prespective in nature. It is
concerned with what decisions ought to be made and hence involves value judgments. This has
two factors:

1) First, it tells us what aim and objectives of a firm should peruse.

2) Secondly, objectives having been defined, it tells us how best to achieve these aims and
objectives in particular situations.
Therefore, Managerial Economics has been described as “Normative Micro Economics of the firm”.

3) Macro Economics is also useful to Managerial Economics since it provides an intelligent

understanding of the environment in which business must operate. This understanding enables
a business executive to adjust in the best possible manner with external forces.

Scope of Managerial Economics and its relations to other subjects:

Scope of Managerial Economics: The scope of Managerial Economics is so wide that it covers
almost all the problems and areas of managers and the business firm. It provides adequate amount of
guidance to business executive in running a business enterprise on prudent commercial practices. It
deals with demand analysis, Demand forecasting, Production function , cost analysis, Inventory
Management, Pricing methods, Capital budgeting, etc.,. A brief description of some important factors
constitute the scope of Managerial Economics is given below.

A) Demand Analysis and Demand Forecasting : Demand Analysis helps in identifying the
various factors influencing the demand for a firm’s product and thus provides guidelines to
manipulate demand. Once the business man knows the factor which is largely influencing
demand for his product, he will be able to take necessary measure to accelerate the demand
with in time.
Before production schedules can be prepared and resources employed, a fore cast of future sale
is essential. This forecast also can serve as guide to management for maintaining or
strengthening market position and enlarging profits. Therefore, Demand Analysis and Demand
 forecasting are essential for business planning and occupies a strategic place in Managerial
Economics.

B) Production Function: Another important area of Managerial Economics is production

function. Once demand is estimated, the next requirements is to identify the sources of
production, Sales of production, establishing relationship among factors production [Land,
labor, capital and organization] one of the chief topics covered under production analysis is
“Economics and diseconomies of sale”.
C) Cost Analysis: The determination of cost, the methods of estimating cost, the relationships
between cost and output are useful for management decisions. The factory causing variations in
cost must be recognized and allowed for if management is to arrive at cost estimates which are
significant for planning purpose. An element of cost uncertainty exist because all the factors
determining economic cost and being able to measure them are necessary steps for more
effective profit planning cost control and often for sound pricing practices.
D) Inventory Management: It refers to stock of raw-material which a firm keeps. The problem
is how much of inventory is the ideal stock. If it is high, unnecessarily capital will be blocked
and as a result of which firm loses an opportunity of making good profit. If inventory is low,
production will be adversely affected. So, manufacturing firm will have to minimize inventory
cost. Ex: Economic order quantity [EOQ] Analysis and ABC analysis [Always Better Control].
E) Advertising: Producing a commodity is one thing, to marketing is another? Therefore,
advertising is an integral part of decision –making and forward planning as the message about
the product should reach the consumer before he thinks of buying as there is no meaning in
producing with out selling.
F) Pricing: It is very important area of Managerial Economics. The success of a business firm
largely depends on the correctness of the price decision taken by it. The important aspects delt
with under this area are: Price determination in various markets, pricing methods, Differential
Pricing, Product line pricing and pricing & its forecasting.
G) Profit Management: The success of any business can be measured by its profits in the long –
run. If the knowledge about the future was perfect, profit analysis would have been a very easy
task. However, in a world of uncertainty, expectations are not always realized so that profit
planning and measurement constitute the difficult area of Managerial Economics. The
important areas covered under this area: Measurement of profit, Profit policies and techniques
of profit like Break-Even-Analysis.
H) Capital Budgeting: Capital is scarce and it has a price. So one has to utilize scarce capital in
the best manner possible so as to get the best out of it. If the managers whishes to arrive at
meaningful decisions, he must have a through understanding of the capital budgeting. The main
topics with are: Cost of Capital, Rate of return, and Selection of Projects.
I) Relation of Managerial Economics with other subjects: Managerial Economics incorporates
certain important ideas from various other subjects if they are found relevant in solving the real
life problems of business enterprises.

1) Managerial Economics and Economics: The relationship between Managerial

Economics and Economics is like that of Engineering Science to physics or of Medicine
to Biology. Managerial Economics has its wider scope lies in applying economic theory
to solve real life problems of enterprises. Both Managerial Economics and Economics
theory deals with problems of scarcity and resources allocation .Business economists
have also found the following main areas of economics as useful in their work.

A) Demand Theory

B) Theory of firm –price, output and investment decisions

 C) Business financing

D) Money and banking

E) National Income and social Accounting

F) Public Finance and Fiscal policy

G) Economics and developing countries

Etc.,

2) Managerial Economics and Accounting: Managerial Economics is closely related to

accounting. Accounting is concerned with recording the financial operations of a
business firm. Indeed, accounting information is one of the principal sources of data
required by a managerial economist for his decision- making process. For instance, the
profit and loss statement of a firm tells how well the firm has done and the information
it contains can be used by managerial economists to throw significant light on the future
course of action – whether it should improve or close down.

3) Managerial Economics and Mathematics: The major problem of the firm is how to
maximize profit, or to optimize scale of production etc., Mathematical concepts &
Technique are widely used in economic logic to solve these problems. Linear
programming, inventory models and game theory find wide applications in Managerial
Economics.

4) Managerial Economics and Statistics: Statistics is important to Managerial

Economics in several ways. Managerial Economics needs the tools of statistics in more
than one way. A successful businessman must correctly estimate the demand for his
product. He should be able to analyze the impact of variations in tastes, fashions and
changes in income and demand. Statistical methods provide a sure base for decision-
making. Statistical tools like theory of probability and forecasting techniques.

5) Managerial Economics and Operational Research: various tools of operating

research like linear programme, theory of game, theory of transportation are helpful to
economist in decision-making the significant relationship between Managerial
Economics and operational research can be highlighted with reference to certain
important problems of Managerial Economics which are solved with the help of OR
techniques. The problems are: Allocation problems, Competition problems, Inventory
problems etc.,

6) Managerial Economics and computer science: Computers have changed the way the
world functions and economic or business activity is no exception. Computers are used
in accounts maintenance inventory and stock controls and supply and demand
predictions.

7) Managerial Economics and Management: Decision-making is one of the major

functions of management. Managerial Economics helps management in arriving at right
decisions at the right time with the help of some concepts like forecasting, Production
function, and proper control functions like inventory control, Statistical control in
setting prices etc.,
 Demand Analysis
Law of Demand and its assumptions
The concept of Demand: The term ‘Demand’ refers to the quantity demanded for a commodity per
unit of time at a given price. It is also defined as a desire backed by an ability and willingness to pay.
Mere desire of a person to purchase a commodity is not his demand. He must posses adequate
resources and must be willing to spend his resources to buy the commodity. It means, demand for any
commodity is based on the following:

1) The desire of a consumer for a product

2) The purchasing power of the consumer, and

3). The willingness to buy it

For example, every one desires to posses Maruti car but only a few have the ability to buy it. So
everybody can not be said to have a demand for car.

The Law of Demand: The relation of price to sales is known in economics as the “Law of Demand”.
It explains the inverse relationship between the demand and price. If the price falls, demand increases
and vice-versa provided the other conditions of demand remain constant. The assumption ‘the other
factors and conditions remain constant’ implies that income of the consumers, prices of the substitutes
and complementary goods, consumer’s taste and preferences and number of consumers, etc remain
unchanged. Thus, the relationship between the variations in price and quantity demanded is known as
“Law of Demand”.

Assumptions of ‘Law of Demand’ are as follows:

Law of Demand holds good when the following things occur:

A) No change in consumer’s taste and preferences.

B) Income of the consumer should remain constant.

C) Prices of other goods should not change.

D) There should be no substitute for the commodity or prices of substitutes remain unchanged

E) There demand for the commodity should be continuous, means it is not of a seasonal profit.

F) .People should not expect any change in the price, availability of product and his income in
near future.

Demand Schedule: The “Law of Demand” can be illustrated through a demand schedule. A demand
schedule is a series of quantities which consumer would like to buy per unit of time at different prices.
In other words it is a table or statement showing how much of a commodity is demanded in a particular
market at different prices. Price- Quantity relation is shown automatically in the form of a table
showing prices and corresponding quantitative. We give an illustration of the “Demand Schedule”
below.
 Demand Schedule

Price of Product Quantity demanded at given price

Rs.5 80 units

Rs.4 100 units

Rs.3 150 units

Rs.2 200 units

Rs.1 300 units

Demand Curve: The “Law of Demand” can also be presented through a demand curve. An example
of the ‘Demand Curve’ is given below

In the above graphical presentation D,D1 is the demand curve of a commodity. The curve
slopes downward from left to right indicating when price rises, less is demanded and when price falls,
more is demanded. This kind of a slope is known as “Negative slope”.

The demand curve concentrates exclusively on the price-quantity relationship. The relationship
between quantity demanded and other variables are not shown by the demand curve. The price quantity
relationship is also expressed algebraically in the form of the following equation.

Q= f(p) means that Quantity demanded is function of price.

Why demand Curve Slopes downward from left to right?
1) The relationship between price and quantity demanded is inverse.

2) As the price of the commodity falls, new consumers purchase the

commodity, as a result, the quantity demand will rise because of that
when the price of the commodity falls, it becomes a cheaper good, so
consumer substitutes the cheaper goods. This effect is called
‘Substitution Effect’.

3) The Existing consumer also purchases additional units, as the commodity

becomes cheaper. This is because of ‘Income Effect’. Means, when price
of a commodity falls, the disposable income of the consumer increases
and the increased disposal income enables the consumer to buy more.

Expectation to the general ‘Law of Demand’:- The ‘Law of Demand’ does not hold good in the
following cases or conditions.

A) Veflen goods: The law does not apply to the commodities which serve as ‘Status Symbol’,
enhance ‘Social Prestige’ or display wealth and richness Ex: gold, precious
stones[Diamonds], rare paintings, costly decorative items, etc. Rich people buy such goods
mainly because their prices are high.

B) Giffen goods:- Giffen goods does not mean any specific commodity. It may be any
commodity much cheaper than its substitutes, consumed by the poor households as essential
consumer goods. If the prices of such goods increases[price of its substitute remaining
constant], its demand increases instead of decreasing. These goods are named after Robert
Giffen[1837-1910].

In Ireland he found that people were so poor that they spent a major part of income on
potatoes and a small part on meat. When the prices of Potatoes rise, they had to
economize on meat even to maintain the same consumption of potatoes. Further, to fill
up the resulting gap in food supply caused by a reduction in meat consumption, more
potatoes had to be purchased because potatoes were still the cheapest food. Thus the
rise in the prices of potatoes led to increased sales of potatoes.

C) Speculative Effect: In case of share trading, when there is an exception of further rise in the
prices of shares, the demand will grow more and more even with a rising prices and vice-versa.

D) Ignorance of consumer: Some consumers think that the product is superior if the price is high
and vice-versa.

E) Fear of Scarcity: If the consumer thinks that the product may not be available in adequate
quantities in near future due to certain reasons, he will definitely purchase more quantities at
current prices[ Even though price is high] with the fear of scarcity or if thinks that there may be
any increase in the price of product in near future, he may buy more at higher prices
Individual Demand: The Quantity demanded by an individual a purchase at a give price is known as
Individual Demand.

Market or Total Demand: The total Quantity demanded by all the purchases together is known as
market demand. The market demand for a commodity can be calculated by adding the quantities
demanded by all the purchases.

Price Demand: If demand of a commodity is influenced by its price only the demand is said to be
price demand which is nothing but ‘Law of Demand’.

Q=f(p)

Income Demand: If a change in quantity demanded of a commodity is caused by income of consumer

provided other factors remain constant

Q= f(I) means that quantity demanded is function of Income.

Cross Demand: If price of one commodity influence the demand of another related commodity [ it
may be substitute or complement], the demand for commodity is called as ‘ Cross Demand’.

Q = f(P) means quantity demanded of product(A) is function of price of product(B).

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 Factors Determining Demand
[Or]
Factors influencing Demand
The demand for a product is determined by a number of factors, Viz., price of the product,
price and availability of the substitutes, consumers income, his own preferences for a commodity,
utility derived from the commodity, demonstration effect, advertisement, credit facility by the seller
and banks, off season discounts, multiplicity in the use of the commodity, population of the country,
consumers expectations regarding the future trend in the price of the product, consumers wealth, past
levels of demand and income, Government policies, etc., But all these factors are not important. We
shall discuss here some important determinants of demand for a product.

1) Price of the commodity: Price is the most important determinant of the quantity demanded of
a commodity. The price quantity relationship is the central theme of demand theory. The nature
of relationship between price of a commodity and its quantity demanded has already been
discussed under the ‘Law of Demand’.

2) Price of substitutes and complementary goods: The demand for a commodity depends also
on the levels of the prices of its substitutes and complementary goods.

Substitutes: Two commodities are deemed to be substitute for each other if changes in the
price of one affects the demand for the other in the same direction. The relation between
demand of a product and the price of its substitute is positive in nature. For instance: Tea and
Coffee are substitutes to each other if a rise in the price of a coffee increases the demand for tea
and versa.

Complements: A commodity is deemed to be a complement of another when it complements the use

of the other. In other words, when the use of any two goods goes together so that their demand changes
[increase or decrease] simultaneously, they are treated as complementary. For example petrol is
complement to motor car, butter and jam are complementary to bread, Technically, two goods are
complements to one another if an increase in the price of one causes a decrease in the demand for a
good and the price of its complement for instance an increase in price of petrol causes a decrease in the
demand for car other things remaining the same.

3) Consumers Income: Income is the basic determinant of the Quantity demanded for a product
as it determines the purchasing power of the consumer. That is why people with higher current
disposable income spend a large amount on goods and services than those with lower income.
For the purpose of income- demand analysis, goods and services may be grouped under four
broad categories, viz (a) Essential consumer goods (b) Inferior goods (c) Normal goods, and
(d) prestige or luxury goods. The relationship between income and different kinds of goods is
presented through the Income demand curves.

a)Essential Consumer goods: The goods and services which fall in this category are
essentially consumed by almost all persons of a society. Quantity demanded of such goods
increases with increase in consumer’s income only up to a certain limit. As below ECG curve
shows consumers demand for these goods increases until his income rises to OY, and beyond this
level of income, it does not. It tells us that proportion expenditure on essential goods increases as
income increases.
 b) Inferior Goods: Inferior and superior are generally known to both consumers and sellers.
However, a commodity is deemed to be inferior if it s demand decreases with the increase in
consumer’s income. Demand for such goods may initially increase with increase in income [say up to
y1] but it decreases when income increases beyond certain level.

c) Normal goods: clothing is the most important examples of this category of goods. Normally,
these goods are demanded in increasing quantities as consumer’s income rises. Demand for normal
goods initially increases rapidly, and later at low rate. With the increase in consumer’s income, its
income elasticity decreases.

d) Luxury or prestige goods: prestige goods are those goods which are consumed mostly by
the rich sections of the society, e.g. precious stones, studded jewellery, costly cosmetics, T.V sets,
refrigerators, decoration items etc,. Demand for such goods arises only beyond a certain level of
consumer’s income. The relationship between income- demands of these category goods is shown by
the following graphical presentation.

4) Consumer taste and preference: Consumer’s taste and preferences play an important role in
determining the demand for a product. Taste and preferences depend, generally, on the social
customs, religious values attached to the commodity, habits of the people, the general life- style
of the society and also the age and sex of the consumer’s. Change in these factors changes
consumer’s taste and preferences. As a result, consumers reduce or give up the consumption of
some goods and include some others in their consumption basket.
5) Consumer’s Expectations: This is another important factor which has important role to play
in determining the demand for goods in the short- run. If consumer expect a rise either in the
price of the commodity in near future or increase in income on account of announcement of
revision of pay-scales or scarcity of certain goods in near future, they would buy more of it at
its current price.

6) Demonstration Effect: When new commodities or new models of existing ones appear in the
market, rich people by them first. Some people by new goods or new models of goods because
they have genuine need for them while others buy because they want to exhibit their affluence.
The purchases by the latter category of the consumers are made out of certain feelings such as
jealousy, competition, equality, social inferiority and desire to raise their social status.
Purchases made on account of these factors are the result of ‘Demonstration Effect’. These
effects have a positive effect on the demand.

7) Snob Effect: When a commodity becomes the thing of common use, some people, mostly
richly, decrease or give-up the consumptions of such goods. This is known as ‘Snob Effect’. It
has negative effect on the demand for the related goods.

8) Consumer- credit facilities : Availability of credit to the consumer from the sellers, banks,
relations and friends or from any other source encourages the consumers to buy more than what
they would buy in the absence of credit facility. That is why the consumers who can borrow
more can consume more than those who can borrow less.

9) Population of the country: Total domestic demand for a product depends also on the size of
the population. Given the price, per capita income, taste and preferences, etc., the larger the
population, the larger the demand for a product. When an increase in the size of population,
demand for the product will increase.

10) Distribution of National Income: Apart from the levels of individual incomes, the distribution
pattern of national income also affects the demand for a commodity. If national income is
evenly distributed, i.e., if majority of population belongs to the lower income groups, market
demand for essential goods [ including inferiors] will be the largest where as the same for the
other kinds of goods will be relatively low.

----------
 Elasticity of Demand
Elasticity of Demand: The ‘Law of Demand’ states that any change in price of a commodity brings
about change in the quantity of a commodity rise demanded. It tells us that when price of the
commodity rises the demand will fall and when fall in price, demand will rise. Though the law of
demand explains the inverse relationship between price and quantity purchased, it fails to explain by
how much the quantity demanded increases as a result of a fall in the price or vice versa . i.e the law of
demand simply tells us the direction of change as a consequence of change in the price and not the rate
at which the change takes place. On the other hand, the elasticity of demanded measures the rate of
change in demand as a result of change in the price. Thus, it is clear that the low of demand as a result
of change in the picture. Thus, it is clear that the law of demand explains the quantitative aspect of
demand where as the elasticity of demand explains the quantitative aspect of demand.

Alfred Marshall who introduced the concept of elasticity of demand in economics, defined as “
The Elasticity of demand in a market is a great or small according to the amount demanded increases
much or little for a given fall in price and diminishes much or little for a given rise in price”.

Kenneth Bolding states that “Elasticity of demand measures the responsiveness of demand to
changes in price”.

By examining the above definitions of the popular economists we can state that the price
elasticity of demand represents the rate change in the demanded as a consequence of rise/ fall in price
of commodity.

In general cases we can say, Elasticity of demand is a quantitative measurement of the change
in demand on account of a given change in any demand determinant [means it is not confined to price].

There are three important types of elasticity of demand:

 Price Elasticity of demand

 Income Elasticity of Demand

 Cross Elasticity of Demand

Price Elasticity of demand : The price elasticity of demand may be defined as the ratio of the
percentage change in demand to percentage change in price. The price elasticity may be measured by
the following way.
Where Ep= Price Elasticity of demand

Q1= Quantity demanded before change in price

Q2= Quantity demanded after change in price

P1= Price before change

P2= Price after change

Income Elasticity of Demand: The Income Elasticity of demand is defined as a ratio of percentage or
proportional change in the quantity demanded to the percentage change in income. It measures the
degree of responsive in quantity demanded due to change in income.

Income Elasticity of Demand [ IE] = Proportionate change in quantity demand

Proportionate change in Income of consumer

Where E I= Income Elasticity of Demand

= Change in quantity demanded

Q1= Quantity demanded before charge in Income

I 1= Income before change

Cross Elasticity of Demand: This may be defined as “the Proportionate change in the quantity
demanded of a particular commodity in response to a change in the price of another related commodity
[related commodity may be substitute or complementary good].
 Ec = Q(A) Q(A) P 1(B)
Q1(A) = Q1(A) P(B)
P1(B)
P(B)

Where EC= Cross Elasticity of demand

Note: Cross Elasticity of demand is positive incase of substitutes and negative in case of
complementary goods.

Significance of Elasticity of Demand: The concept of Elasticity of demand is of much practical

importance. Because elasticity of demand helps the government and business man in so many ways as
under.

- It guided the business in fixing the right price for commodity.

- It decides the level of production.

- It helps in determining rewards to factors of production.

- It will also influence wages.

- It helps government before fixing or imposing price control on good.

- It helps government in formulating tax policies.

- It helps in deciding about industrial and Economic policies.

Different relationships between price and quality:

( Or)
Types of Price Elasticity of Demand: Generally, a small fall in the price of a commodity may
increase the demand of a commodity considerably. But the change in demand will not be the same for
all commodities. It differs from product to product. For example Necessary goods such as Rice and
Wheat are purchased in a fixed quantity even the price of these commodities is high or low. So, the
demands for necessary goods are in elastic. When the price of these goods fall, the demand will
increase considerably, Hence, there are five different relationships possible between a change in price
and quantity demanded as follows:

a) Perfectly Elastic Demand: No change or a small change in price leads to an unlimited extension or
infinite change in price leads to an unlimited extension or infinite change in demand, it is called
‘Perfectly Elastic Demand’. Ex: A small rise in price causes the demand to fall to zero i.e, E= ,
Inthis case, the shape of demand curve is horizontal to ‘X’ axis

b) Perfectly Inelastic Demand: Demand is said to be inelastic when the quantity demanded remains
unchanged irrespective of any rise or fall in the price commodity. Means responsiveness to a change in
price is nil. The shape of demand curve in this case is vertical to ‘Y’ axis.

c) Relatively
Inelastic Demand:
In this case, the
proportionate
change in the
quantity demanded
is less than that of
price. A large
change in price
leads to a small
change in quantity
demanded. The
shape demand curve
is more of steps.
 d) Relatively Elastic Demand: The proportionate change in the quantity demanded is greater than
that of price. In other words a small change in demand. Elasticity of demand is greater than one. The
shape of demand is greater than one. The shape of demand curve is more of a flat.

e) Unity Elasticity of Demand: When proportionate change in price brings about an equal
proportionate change in the demand, elasticity of demand is equal to one. The shape of demand curve
is slope line.
Factors determining or influencing elasticity of demand: The following factors will influence the
elasticity of demand for any product
1) Nature of commodity
2) Number of uses of a commodity
3) Availability of substitutes
4) Durability of commodity
5) Possibility of postponement purchase
6) Proportion of income spent on commodity
7) Habitual necessaries
8) Time period under consideration
9) Income level
10) Purchase frequency of a product

A brief description of above factors is given under:

1) Nature of Commodity: The elasticity of demand depends upon the nature of a commodity.
Generally, the demand for necessaries will be inelastic, where as the demand for luxuries will be
elastic however, we can not make a generalization that the demand for luxuries is elastic and the
demands for necessaries are inelastic due to the following reasons:

A) Certain goods may be luxuries for some people but necessaries for others. For example: A
car may be luxury for a common man but it is necessary for a doctor. So, the elasticity for the same
commodity may differ from place to place from person to person.

B) If the Commodity has close substitutes available at reasonable prices, then the demand for
the commodity will be elastic. When commodity has no substitute has inelastic demand. For example
salt has no substitute; therefore, the demand for salt is always inelastic. Wheat is necessary good, but it
has substitutes. The demand for wheat can be elastic even though it is necessary.
2) Number of uses of Commodity: A commodity having a variety of uses has comparatively elastic
demand i.e electricity on the other hand, the demand is inelastic for commodity having limited or
single use. For Ex: Steel can be used for many purposes. A slight fall in its price will bring both
demand form many quarters and hence demand is elastic.

3) Availability of Substitutes: If the Commodity has no substitutes its demand will be inelastic. If
commodity has substitutes, the demand will be elastic. Example: If bus fairs rise, people will use train
or any other cheap means of transportation. Therefore bus passenger services have elastic demand.

4) Durability of Commodity: The demand for durable goods such as Radio, Television and Fan has
elastic demand. When the price of these goods rises, people may prefer to get the old things repaired
than to buy new things. Therefore, the demand for durables will fall.

5) Possibility of Postponement of Purchase of Product: Price elasticity is also effected by the

possibility of postponement of product purchase. If the consumption of a commodity can not be
postponed than it will have inelastic demand. On the other hand, if the consumption of a commodity
can be postponed then it will have elastic demand. For example: Salt, food grains can not be
postponed. Hence, they have inelastic demand.

6) Proportion of income spent on commodity: If a consumer spends only a small amount on the
commodity, its demand will be inelastic. For example: The amounts we spent on news papers, Match
Boxes, Shoe polish etc., are very small. Therefore, an even if the price of these products raises the
demand will not fall on the other hand, if the amount spent on commodity is large the demand will be
elastic. Ex: T.V, Refrigerator etc.,

7) Habitual necessaries: If the consumers are addicted to a commodity due to habit and customs the
demand for commodity will be inelastic. Because once consumer is addicted to a product, he will not
reduce the consumption even price of the product is increasing, For example: Cigarettes, Liquor etc.,

8) Time Period under Consideration: Time plays an important role in determining elasticity of
demand. Generally, demand is inelastic during short period and elastic during the long period. This is
because in the long- run consumer can changes their consumption habit in favor of cheaper substitutes
against the expensive commodities. Therefore, in the long- run- elasticity is generally higher for all
commodities.

9) Income level: Higher income group people are less affected by price changes than low income
group people. Demand for high priced and quality goods is inelastic for high income groups where as
the same is elastic for low income group people. A rich man will not certain consumption of Fruits and
Milk even if the prices rise significantly and will continue to purchase the same quantities as before.
But a poor man can not do so. Hence, the demand for the fruits and milk is inelastic.

10) Purchase frequency of a Product: If the frequency of purchase of a product is very high, its
demand is likely to be more price elastic than in the case of a product which is purchased less often.

Demand Forecasting and its Methods

Meaning of Demand Forecasting: Demand forecasting is an estimation of the future demand for any
product. As we know that, there is a relation between the input and output, so unless we are sure about
a fixed quantity of output there is no meaning in acquiring the input. Thus, one has to decide about the
future demand, such that he can plan his investment strategy. There is no meaning in producing if there
is no market for the said products. So, necessary steps should be taken to know the future such that we
can plan our strategy to meet the demand in near future is called as demand forecasting.

Significance of Demand forecasting: Demand forecasting helps in inventory management, production

planning and also sales management, financial management. It helps production department in
maintaining proper levels of stores and raw material by that it reduces unnecessary burden on financial
management. It also helps production Management to plan for the reduction or expansion of plant
capacity and helps in marketing and distribution of the finished products with the help of budgets it
will be very convenient for the finance department to provide funds for various purposes from various
sources with out much difficulty.

Factors involved in Demand Forecasting: There are at least six factors involved in demand forecasting.
They are

1) Forecast Period: It is very important factor to be taken into consideration ‘How far
ahead’? This problem is solved by having both short-run and long-run forecasting. How far
ahead the long-term forecasts go depends upon the nature of the industry. It may be
necessary to look 20 years a head in case of certain industries because of the close link with
capital expenditure forecasting. For example: Petroleum companies, shipping companies,
paper mills in view of the long life of the fixed assets, do have to forecast well deep into
the future. Short- term forecasting may cover a period of three months, six months or one
year. Which period is to chosen depends on the nature of business. When demand fluctuates
from one month to another, a very short period should be taken.

2) Level of forecasting: At what level and how many levels the forecasting activity be under
taken? Is another questions arises while planning demand forecasting. Demand. Demand
forecasting may be undertaken at three different level such as: Macro level, Industry level
and Firm level.

3) Should the forecast be general or Specific?: The firm may find a general forecast useful,
but it usually needs to be broken down into commodity/ product-wise forecasts and
forecasts by area of sale.

4) Type of forecasting method: Selection of suitable forecasting method is another activity

which should be given proper attention. This is because of that the problems and methods
of forecasting are usually different for new product from those for products already well
established in the market.

5) Classification of products: For selection of suitable demand forecasting method,

classifying the products into different types is another activity to be undertaken. As each
type of product has different patterns of demand, it is important to classify products as
producer goods, consumer durables, or consumer goods and services.

6) Paying attentions towards certain special factors: Special factors peculiar to the product
and market must be taken into account in every forecast. Factors like: A) Nature of the
competition in the market.

B) Possibility of error or inaccuracy in the forecast.

C) Political development in the country like general elections

 Etc.,

D) Sociological factors, changes in cultural environment.

E) The role of psychology in demand.

F) What people think about products and brands?

Etc. are to be considered while forecasting demand.