Assignment No 1

Name: Vipul Narayan Sharma

Q.no.1 what is meant by business Economics? Explain its Nature and Scope?
Ans: - 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, labor 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.
Different aspects of business need attention of the chief executive. He may be
called upon to choose a single option among the many that may be available to him. It
would he in the interest of the business to reach an optimal decision- the one that
promotes the goal of the business firm. A scientific formulation of the business problem
and finding its optimal solution requires that the business firm is he equipped with a
rational methodology and appropriate tools.
Business economic meets these needs of the business firm. This is illustrated
in the following presentation.
 Economic Theory and Methodology
 Decision problems in Business
 Business Economic
 Application of Economic Theory and Methodology to solving Business problems.
 Optimal Solution to Business Problems
It may be that business economics serves as a bridge between economic theory and
decision-making in the context of business.
According to Mc Nair and Meriam, “Business economic consists of the use
of economic modes of thought to analyses business situations.”
Siegel man has defined managerial economic (or business economic) as
“the integration of economic theory with business practice for the purpose of
facilitating decision-making and forward planning by management.”
We may, therefore, define business economic as that discipline which
deals with the application of economic theory to business management. Business
economic thus lies on the borderline between economic and business management
and serves as a bridge between the two disciplines.
 Assignment No 1
Name: Vipul Narayan Sharma

 Nature of Business Economics:

Business Economics is a Science: Science is a
systematized body of knowledge which establishes cause and effect relationships.
Business Economics integrates the tools of decision sciences such as Mathematics,
Statistics and Econometrics with Economic Theory to arrive at appropriate strategies for
achieving the goals of the business enterprises. It follows scientific methods and
empirically tests the validity of the results.

Based on Micro Economics: Business Economics is based largely on Microeconomics.

A business manager is usually concerned about achievement of the predetermined
objectives of his organization so as to ensure the long-term survival and profitable
functioning of the organization. Since Business Economics is concerned more with the
decision making problems of individual establishments, it relies heavily on the techniques
of Microeconomics.

Incorporates elements of Macro Analysis: A business unit does not operate in a

vacuum. It is affected by the external environment of the economy in which it operates
such as, the general price level, income and employment levels in the economy and
government policies with respect to taxation, interest rates, exchange rates, industries,
prices, distribution, wages and regulation of monopolies. All these are components of
Macroeconomics. A business manager must be acquainted with these and other
macroeconomic variables, present as well as future, which may influence his business
environment.

Business Economics is an art: it involves practical application of rules and principles for
the attainment of set objectives.

Use of Theory of Markets and Private Enterprises: Business Economics largely uses
the theory of markets and private enterprise. It uses the theory of the firm and resource
allocation in the backdrop of a private enterprise economy.

Pragmatic in Approach: Microeconomics is abstract and purely theoretical and analyses

economic phenomena under unrealistic assumptions. In contrast, Business Economics is
pragmatic in its approach as it tackles practical problems which the firms face in the real
world.

Interdisciplinary in nature: Business Economics is interdisciplinary in nature as it

incorporates tools from other disciplines such as Mathematics, Operations Research,
Management Theory, Accounting, and marketing, Finance, Statistics and Econometrics.
 Assignment No 1
Name: Vipul Narayan Sharma

Normative in Nature: Economic theory has developed along two lines – positive and
normative. A positive or pure science analyses cause and effect relationship between
variables in an objective and scientific manner, but it does not involve any value
judgement.  As against this, a normative science involves value judgement. It is
prescriptive in nature and suggests ‘what should be’ a particular course of action under
given circumstances. Welfare considerations are embedded in normative science.

Business Economics is generally normative or prescriptive in nature. It suggests the

application of economic principles with regard to policy formulation, decision-making
and future planning. However, if the firms are to establish valid decision rules, they must
thoroughly understand their environment.

Scope of Business Economics:

The scope of Business Economics may be discussed under the following two heads:-

1. Microeconomics applied to operational or internal Issues

Demand Analysis and Forecasting: Demand analysis pertains to the behavior of

consumers in the market. It studies the nature of consumer preferences and the effect of
changes in the determinants of demand such as, price of the commodity, consumers’
income, prices of related commodities, consumer tastes and preferences etc.

Demand forecasting is the technique of predicting future demand for goods and services
on the basis of the past behavior of factors which affect demand. Accurate forecasting is
essential for a firm to enable it to produce the required quantities at the right time and to
arrange, well in advance, for the various factors of production viz., raw materials, labor,
machines, equipment, buildings etc. Business Economics provides the manager with the
scientific tools which assist him in forecasting demand.

Production and Cost Analysis: Production theory explains the relationship between
inputs and output. A business economist has to decide on the optimum size of output,
given the objectives of the firm. He has also to ensure that the firm is not incurring undue
costs. Production analysis enables the firm to decide on the choice of appropriate
technology and selection of least - cost input-mix to achieve technically efficient way of
producing output, given the inputs. Cost analysis enables the firm to recognize the
behavior of costs when variables such as output, time period and size of plant change.
The firm will be able to identify ways to maximize profits by producing the desired level
of output at the minimum possible cost.

Inventory Management: Inventory management theories pertain to rules that firms can
use to minimize the costs associated with maintaining inventory in the form of ‘work-in-
 Assignment No 1
Name: Vipul Narayan Sharma
process,’ ‘raw materials’, and ‘finished goods’. Inventory policies affect the profitability
of the firm. Business economists use methods such as ABC analysis, simple simulation
exercises and mathematical models to help the firm maintain optimum stock of
inventories.

Market Structure and Pricing Policies: Analysis of the structure of the market provides
information about the nature and extent of competition which the firms have to face. This
helps in determining the degree of market power (ability to determine prices) which the
firm commands and the strategies to be followed in market management under the given
competitive conditions such as, product design and marketing. Price theory explains how
prices are determined under different kinds of market conditions and assists the firm in
framing suitable price policies.

Resource Allocation: Business Economics, with the help of advanced tools such as
linear programming, enables the firm to arrive at the best course of action for optimum
utilization of available resources.

Theory of Capital and Investment Decisions: For maximizing its profits, the firm has
to carefully evaluate its investment decisions and carry out a sensible policy of capital
allocation. Theories related to capital and investment provide scientific criteria for choice
of investment projects and in assessment of the efficiency of capital. Business Economics
supports decision making on allocation of scarce capital among competing uses of funds.

Profit Analysis: Profits are, most often, uncertain due to changing prices and market
conditions. Profit theory guides the firm in the measurement and management of profit
under conditions of uncertainty. Profit analysis is also immensely useful in future profit
planning.

Risk and Uncertainty Analysis: Business firms generally operate under conditions of
risk and uncertainty. Analysis of risks and uncertainties helps the business firm in
arriving efficient decisions and in formulating plans on the basis of past data, current
information and future prediction.
 Assignment No 1
Name: Vipul Narayan Sharma

2. Macroeconomics applied to environmental or external issues

Environmental factors have significant influence upon the functioning and performance
of business. The major macro-economic factors are related to:-

 the type of economic system

 stage of business cycle
 The general trends in national income, employment, prices, saving and investment.
 government’s economic policies like industrial policy, competition policy,
monetary and fiscal policy, price policy, foreign trade policy and globalization
policies
 working of financial sector and capital market
 Socio-economic organizations like trade unions, producer and consumer unions
and cooperatives.
 Social and political environment.

Business decisions cannot be taken without considering these present and future
environmental factors. As the management of the firm has no control over these factors, it
should fine-tune its policies to minimize their adverse effects.
 Assignment No 1
Name: Vipul Narayan Sharma

Q.No.2:- What is Circular Flow? Explain its Types.

Ans: The all-pervasive economic problem is that of scarcity which is solved by three
institutions (or decision-making agents) of an economy. They are households (or individuals),
firms and government. They are actively engaged in three economic activities of production,
consumption and exchange of goods and services. These decision-makers act and react in such a
manner that all economic activities move in a circular flow.

First, we discuss their nature and role in decision-making.

ADVERTISEMENTS:

Households:

Households are consumers. They may be single-individuals or group of consumers taking a joint
decision regarding consumption. They may also be families. Their ultimate aim is to satisfy the
wants of their members with their limited budgets.

Households are the owners of factors of production—land, labour, capital and entrepreneurial
ability. They sell the services of these factors and receive income in return in the form of rent,
wages, and interest and profit respectively.

Firms:

ADVERTISEMENTS:

The term firm is used interchangeably with the term producer in economics. The decision to
manufacture goods and services is taken by a firm. For this purpose, it employs factors of
production and makes payments to their owners. Just as household’s consumer goods and
services to satisfy their wants, similarly firms produce goods and services to make a profit.

The term ‘firm’ includes joint stock companies like DCM, TISCO etc., public enterprises like
IOC, STC, etc., partnership concerns, cooperative societies, and even small and big trading shops
which do not manufacture the commodities they sell.

Government:

The government plays a key role in all types of economic systems—capitalist, socialist and
mixed. In a capitalist economy, the government does not interfere. It simply establishes and
protects property rights. It sets standards for weights and measures, and the monetary system.

ADVERTISEMENTS:
 Assignment No 1
Name: Vipul Narayan Sharma

In a socialist economy, the role of the government is very extensive. It owns and regulates the
entire production and consumption processes of the economy, and fixes prices of goods and
services. In a mixed economy, the government strengthens the market system.

It removes its defects by regulating the activities of the private sector and by providing
incentives to it. The government also uses resources to produce goods and services itself which
are sold to households and firms. These decision-making agents take economic decisions to
produce goods and services and to exchange them in order to consume them for satisfying the
wants of the whole economy.

Production, consumption and exchange are the three main activities of the economy.
Consumption and production are flows which operate simultaneously and are interrelated and
interdependent. Production leads to consumption and consumption necessitates production.

In other words, production is a means (beginning) and consumption is the end of all economic
activities. Both production and consumption, in turn, depend upon exchange. Thus these two
flows are interrelated and interdependent through exchange.

The Circular Flow in a Two-Sector Economy:

In a simplified economy with only two types of economic agents, households or consumers and
business firms, the circular flow of economic activity is shown in Figure 10. Consumers and
firms are linked through the product market where goods and services are sold. They are also
linked through the factor market where the factors of production are sold and bought.

Consumers and firms have a dual role, and exchange with one another in two distinct
ways:
 Assignment No 1
Name: Vipul Narayan Sharma

(1) Consumers or households own all the factors of production, that is, land, labour, capital and
entrepreneurship, which are also called productive resources. They sell them to firms for
producing goods and services.

In the diagram, the sale of goods and services by firms to consumers in the product market is
shown in the lower portion of the inner circle from left to right; and the sale of their services to
firms by households or consumers in the factor market is shown in the upper portion of the inner
circle from right to left. These are the real flows of goods and services from firms to consumers
which are linked with productive resources from consumers to firms through the medium of
exchange or barter.

ADVERTISEMENTS:

(2) In a modem economy, exchange takes place through financial flows which move in the
reverse direction to the “real” flows. The purchase of goods and services in the product market
by consumers is their consumption expenditure which becomes the revenue of the firms and is
shown in the outer circle of the lower portion from right to left in the diagram.

The expenditure of firms in buying productive resources in the factor market from the consumers
becomes the incomes of households, which is shown in the outer circle of the upper portion from
left to right in the diagram.
 Assignment No 1
Name: Vipul Narayan Sharma

The Circular Flow in a Three-Sector Economy:

So far we have been working on the circular flow of a two-sector model of an economy. To this
we add the government sector so as to make it a three-sector closed model of circular flow of
economic activity. For this, we add taxes and government purchases (or expenditure) in our
presentation.

Taxes are outflows from the circular flow and government purchases are inflows into the circular
flow. The circular flow in a three-sector economy is illustrated in Figure 11.

ADVERTISEMENTS:

First, take the circular flow between the household sector and the government sector. Taxes in
the form of personal income tax and commodity taxes paid by the household sector are outflows
(or leakages) from the circular flow. But the government purchases the services of the
households, makes transfer payments in the form of old age pensions, unemployment relief,
sickness benefit, etc., and also spends on them to provide certain social services like education,
health, housing, water, parks and other facilities.

All such expenditures by the government are inflows (injections) into the circular flow. Next
take the circular flow between the business sector and the government sector. All types of taxes
paid by the business sector to the government are leakages from the circular flow.

On the other hand, the government purchases all its requirements of goods of all types from the
business sector, gives subsidies and makes transfer payments to firms in order to encourage their
production. These government expenditures are injections into the circular flow.

ADVERTISEMENTS:

Now we take the household, business and government sectors together to show their inflows and
outflows in the circular flow. As already noted, taxes are a leakage from the circular flow. They
 Assignment No 1
Name: Vipul Narayan Sharma

tend to reduce consumption and saving of the household sector. Reduced consumption, in turn,
reduces the sales and incomes of the firms.

On the other hand, taxes on business firms tend to reduce their investment and production. The
government offsets these leakages by making purchases from the business sector and buying
services of the household sector equal to the amount of taxes. Thus inflows (injections) equal
outflows (leakages) in the circular flow.

Figure 11 shows that taxes flow out of the household and business sectors and go to the
government. The government purchases goods from firms and also factors of production from
households. Thus government purchases of goods and services are an injection in the circular
flow and taxes are leakages in the circular flow.

If government purchase exceeds net taxes then the government will incur a deficit equal to the
difference between the two, i.e., government expenditure and taxes. The government finances its
deficit by borrowing from the capital market which receives funds from the household sector in
the form of saving.

On the other hand, if net taxes exceed government purchases the government will have a budget
surplus. In this case, the government reduces the public debt and supplies funds to the capital
market which are received by the business sector.

The Circular Flow in a Four-Sector Economy:

So far the circular flow has been shown in the case of a closed economy. But the actual economy
is an open one where foreign trade plays an important role. Exports are an injection or inflows
into the circular flow of money. On the other hand, imports are leakages from the circular flow.

ADVERTISEMENTS:

They are expenditure s incurred by the household sector to purchase goods from foreign
countries. These exports and imports in the circular flow are shown in Figure 12.
 Assignment No 1
Name: Vipul Narayan Sharma

Take the inflows and outflows of the household, business and government sectors in relation to
the foreign sector. The household sector buys goods imported from abroad and makes payment
for them which is a leakage from the circular flow of money. The householders’ ma receives
transfer payments from the foreign sector for the services rendered by them in foreign countries.

On the other hand, the business sector exports goods to foreign countries and its receipts are an
injection in the circular flow or money. Similarly, there are many services rendered by business
firms to foreign countries such as shipping, insurance, banking, etc. for which they receive
payments from abroad.

They also receive royalties, interests, dividends, profits, etc. for investments made in foreign
countries. On the other hand, the business sector makes payments to the foreign sector for
imports о capital goods, machinery, raw materials, consumer goods, and services from abroad.
These are the leakages from the circular flow of money.

Like the business sector, modern governments also export and import goods and services, and
lend to and borrow from foreign countries. For all exports of goods, the government receives
payments from abroad.

ADVERTISEMENTS:

Similarly, the government receives payments from foreigners when they visit the country as
tourists and for receiving education, etc., and also when the government provides shipping,
insurance and banking services to foreigners through the state-owned agencies.
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Name: Vipul Narayan Sharma

It also receives royalties, interests, dividends, etc. for investments made abroad. These are
injections into the circular flow of money. On the other hand, the leakages are payments made to
foreigners for the purchase of goods and services.

Figure 12 shows the circular flow of money of the four sector open economy with saving, taxes
and imports shown as leakages from the circular flow on the right hand side of figure, and
investment, government purchases and exports as injections into the circular flow, on the left
side of the figure.

Further, imports, exports and transfer payments have been shown to arise from the three
domestic sectors—the household, the business and the government. These outflows and inflows
ass through the foreign sector which is also called the “Balance of Payments Sectors”.
 Assignment No 1
Name: Vipul Narayan Sharma

Q.no.3:- What is Law of Demand? Why does demand curve slopes

downward?

Ans: The law of demand is one of the most fundamental concepts in economics. It works with
the law of supply to explain how market economies allocate resources and determine the prices
of goods and services that we observe in everyday transactions. The law of demand states
that quantity purchased varies inversely with price. In other words, the higher the price, the lower
the quantity demanded. This occurs because of diminishing marginal utility. That is, consumers

Use the first units of an economic good they purchase to serve their most urgent needs first, and
use each additional unit of the good to serve successively lower valued ends.

Downward sloping of demand curve-The demand of a product refers to the desire of acquiring
it by the consumer but backed by his purchasing power and willingness to pay the price. The law
of demand states that there is an inverse proportional relationship between price and demand of a
commodity. When the price of commodity increases, its demand decreases.

Similarly, when the price of a commodity decreases its demand increases. The law of demand
assumes that the other factors affecting the demand of a commodity remain the same.

Thus, the demand curve is downward sloping from left to right. Let us discuss in detail why
demand curve slopes downward.

Causes of Downward Sloping of Demand Curve

 Law of diminishing the marginal utility
 Substitution effect
 Income effect
 New buyers
 Old buyers

1. Law of diminishing the marginal utility

The law of diminishing marginal utility states that with each increasing quantity of the
commodity, its marginal utility declines.

For example, when a person is very hungry the first chapatti that he eats will give him the most
satisfaction. As he will consume more chapattis, his level of satisfaction will diminish.
 Assignment No 1
Name: Vipul Narayan Sharma
Thus, when the quantity of goods is more, the marginal utility of the commodity is less. Thus,
the consumer is not willing to pay more price for the commodity and its demand will decline.

Also, when the price of the commodity is low, its demand increases.

Hence, the demand curve slopes downwards from left to right.

2. Substitution effect

Let us understand this with an example. Tea and coffee are substitute goods. If the price of tea
rises, consumers will shift to coffee. This will decrease the demand for tea and increase the
demand for coffee. Thus, the demand curve of tea will slope downwards.

3. Income effect

Income effect refers to the change in the real income or the purchasing power of the consumers.
When the price level falls the purchasing power of the consumer’s increases and they buy more
goods. Similarly, when the price level rises, the purchasing power of the consumer’s decreases
and they buy less quantity of goods.

4. New buyers

Due to the fall in the prices of a commodity new buyers get attracted towards it and buy it. Thus,
this increases the demand for the commodity.

5. Old buyers

When the prices of the goods fall the old buyers tend to buy more goods than usual thereby
increasing its demand. This causes the downward sloping of demand curve
 Assignment No 1
Name: Vipul Narayan Sharma
Q.No.4:- Explain the types of price elasticity. Elaborate the method of
measuring the price elasticity of demand?
Ans: The price elasticity of demand (PED) measures the change in demand for a good in
response to a change in price.

The price elasticity of demand (PED) is a measure that captures the responsiveness of a
good’s quantity demanded to a change in its price. More specifically, it is the percentage
change in quantity demanded in response to a one percent change in price when all other
determinants of demand are held constant.

The formula for the coefficient of PED is:

PED=%change in quantity demanded

%change in price

The law of demand states that there is an inverse relationship between price and demand
for a good. As a result, the PED coefficient is almost always negative. However,
economists tend to ignore the sign in everyday use. Only goods that do not conform to
the law of demand, such as Veblen and Giffen goods, have a positive PED.

The numerical values for the PED coefficient could range from zero to infinity. In
general, the demand for a good is said to be inelastic (or relatively inelastic) when the
PED is less than one (in absolute value): that is, changes in price have a less than
proportional effect on the quantity of the good demanded. The demand for a good is said
to be elastic (or relatively elastic) when its PED is greater than one. In this case, changes
in price have a more than proportional effect on the quantity of a good demanded.

A PED coefficient equal to one indicates demand that is unit elastic; any change in price
leads to an exactly proportional change in demand (i.e. a 1% reduction in demand would
lead to a 1% reduction in price).

A PED coefficient equal to zero indicates perfectly inelastic demand. This means that
demand for a good does not change in response to price.
 Assignment No 1
Name: Vipul Narayan Sharma

Perfectly Inelastic Demand: When demand is perfectly inelastic, quantity demanded for
a good does not change in response to a change in price.

Finally, demand is said to be perfectly elastic when the PED coefficient is equal to
infinity. When demand is perfectly elastic, buyers will only buy at one price and no other.

Perfectly Elastic Demand: When the demand for a good is perfectly elastic, any increase
in the price will cause the demand to drop to zero.

Measuring the Price Elasticity of Demand

The price elasticity of demand (PED) is calculated by dividing the percentage change in
quantity demanded by the percentage change in price.
 Assignment No 1
Name: Vipul Narayan Sharma

The price elasticity of demand (PED) captures how price-sensitive consumers are for a given
product or service by measuring the responsiveness of quantity demanded to changes in the
good’s own price. This is in contrast to measuring the responsiveness of the good’s demand to a
change in price for some other good (a complement or substitute), which is called the cross-price
elasticity of demand. The own-price elasticity of demand is often simply called the price
elasticity.

The following formula is used to calculate the own-price elasticity of demand:

Elasticity=%Change in Quantity Demanded

%Change in Price

The formula above usually yields a negative value because of the inverse relationship between
price and quantity demanded. However, economists often disregard the negative sign and report
the elasticity as an absolute value. For example, if the price of a good increases by 5 percent and
the quantity demanded decreases by 5 percent, then the elasticity at the initial price and quantity
is -5%/5% = -1. This number is likely to be reported simply as 1.

There are a few other important points to note about the coefficient value provided by this
formula. First, the elasticity coefficient is a pure number, meaning that it does not have units of

measurement associated with it. Second, the coefficient value can range from zero to negative
infinity. Finally, the result provided by the formula will be accurate only when the changes in
price and quantity are small. The result will be less accurate when the changes are large.

Since PED is based off of percent changes, the starting nominal quantity and price matter. At low
prices and high quantities, the PED is therefore more inelastic. For example, a drop in the price
of $1 from a starting price of $100 is a 1% drop, but if the starting price is $10, it is a 10% drop.
Similarly, at high prices and low quantities, PED is more elastic.
 Assignment No 1
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Price Elasticity of Demand and Revenue: PED is based off of percent changes, so the starting
nominal values of price and quantity are significant.