Business Economics and Demand

A kirana store owner has ₹50,000 to spend. She could stock a new brand of atta, buy a second fridge, or keep the cash for the festival rush. Each choice rules out the others, and none comes with a guaranteed result.

The terms business economics and managerial economics are used for the same subject. The next concept gives its classic definitions.

At the kirana store, an illustration. Economics turns the owner's worry into four questions she can work on.

Opportunity cost is the value of the best alternative given up. Suppose the same ₹50,000 could earn the owner ₹4,000 a year in extra stock. Then that ₹4,000 is a real cost of the fridge, though no account will show it.

Don't confuse business economics with accounting. Accounting records what has already happened, in rupees paid and received. Business economics looks ahead at choices, and it counts costs that appear in no account, such as the income given up.

Where it breaks. Economic models simplify. They assume that people choose rationally, that other things stay equal and that data exist. A small firm often has only the owner's judgement, so the tools frame the question more often than they settle it.

For exams. Treat business economics and managerial economics as one subject. Expect questions on its definition and on the decisions it serves: production, pricing, investment and risk management.

The owner of an auto-parts plant in Pune must decide whether to add a second shift. Part of the answer lies inside the firm, in orders and costs. Part lies outside it, in interest rates and the car market.

It links economic theory with business practice. Writers have defined it in similar ways; exams ask you to match each definition to its author.

Nature.

• Mainly microeconomic: it studies one firm. It uses macroeconomics, the study of the whole economy, to understand the environment the firm works in.
• Normative: it says what the firm should do, not only what firms do.
• Pragmatic and decision-oriented: it aims at an answer a manager can use.
• Forward-looking under uncertainty: every decision concerns a future nobody knows.
• Conceptual and quantitative: it draws on statistics, mathematics, operations research and accounting.

Scope. It has an inside and an outside.

Why it matters. It applies theory to real problems: what to produce, how much, by which technique, at what price, and where to invest. It supports forecasts of demand, cost and price, and it helps a firm plan for an uncertain environment.

Objectives. The traditional assumption is profit maximisation. Firms may pursue other goals: sales revenue (William Baumol), growth (Robin Marris), or a satisfactory level of performance rather than the maximum (Herbert Simon's satisficing).

Don't confuse normative with positive economics. A positive statement describes what is, and can be tested, such as "a 10% price rise cuts sales by 15%". A normative statement says what should be done, such as "so we should not raise the price". Managerial economics uses positive analysis to reach normative advice.

Where it breaks. Profit maximisation is hard to apply. It does not say whose profit, or over which period: this year's or the next ten years'. Managers also lack full information, which was Simon's point.

For exams. Match each definition to its writer, and remember Joel Dean (1951) for the first textbook. Sort topics into operational and environmental scope. Pair Baumol with sales, Marris with growth and Simon with satisficing.

A college fest committee has ₹2 lakh. A band costs ₹1.5 lakh and food stalls ₹1 lakh, so it cannot have both. Is economics about raising more money, about people's well-being, or about choosing well? Each famous definition gives a different answer.

Five writers, over about 170 years, put the weight on five different things.

Robbins applied to the fest. The ends are many: music, food, decoration. The means, ₹2 lakh, are scarce and have alternative uses. If the committee books the band, the food stalls it gives up are the opportunity cost of that choice.

How each answered the one before. Smith's book, An Inquiry into the Nature and Causes of the Wealth of Nations, put wealth at the centre. Marshall moved the focus to people: economics studies mankind in the ordinary business of life, and the material requisites of well-being. Robbins objected that "material" leaves out services, such as a teacher's or a doctor's, which are scarce and paid for. Robbins's own definition says little about unemployment, which Keynes made central in 1936, or about growth, which Samuelson's definition includes.

Don't confuse Marshall's "welfare" with the welfare state. Marshall meant material well-being: income and the things it buys. He was not writing about government benefits.

Where it breaks. No single definition covers all that economists now study. Modern textbooks usually combine them: scarcity and choice at the core, with the whole economy and growth added.

For exams. Match writer, year and emphasis. The books are The Wealth of Nations (1776), Principles of Economics (1890), An Essay on the Nature and Significance of Economic Science (1932), The General Theory of Employment, Interest and Money (1936) and Samuelson's Economics (1948).

Smith wealth, Marshall welfare, Robbins scarcity, Keynes employment, Samuelson growth.

In a Diwali sale, a student wants a ₹60,000 phone but has ₹15,000. Her uncle could afford it but has no interest in phones. For the shop, neither of them is demand.

A want becomes demand only when the buyer can pay and intends to. Demand also has a time period: 200 cups of tea a day is a different demand from 200 cups a month.

Demand is the whole relationship between price and quantity. Quantity demanded is the amount bought at one specific price. That difference decides what a change is called.

At a kirana store, an illustration. A brand of biscuits sells 100 packets a week at ₹20. If the price falls to ₹18 and sales rise, quantity demanded has expanded. If a new housing society opens nearby and sales reach 130 packets at the same ₹20, demand has increased: the curve has shifted.

Determinants of demand

• Price of the good itself.
• Income: for normal goods demand rises with income; for inferior goods it falls, as buyers move to better options.
• Tastes and preferences.
• Prices of related goods: a dearer substitute (coffee, for a tea drinker) raises demand; a dearer complement (petrol, for a two-wheeler) lowers it.
• Expected future prices: if buyers expect a rise, they buy more now.
• Population: more buyers, more demand.
• Government policy, such as taxes and subsidies.

Don't confuse an increase in demand with an expansion of quantity demanded. Only a change in the good's own price moves you along the curve; everything else shifts it. Cost of production is a supply-side factor and does not determine demand. It can change the price, and so the quantity demanded, but it is not on the list.

Where it breaks. "Other things remaining the same" rarely holds in a real market. Prices, incomes and tastes change together, so a firm finds it hard to tell a movement from a shift in its own sales data.

For exams. Expect "which of these shifts the demand curve?" A change in the good's own price never does. Also expect the three parts of effective demand.

A snack stall's sales depend on its price, but also on the weather, the stall next door and payday. To forecast sales or test a price, a manager writes all of these down in one line.

In its simplest form, demand depends on the good's own price, D_x = f(P_x). In full:

Here P_x is the good's own price, P_r the prices of related goods (substitutes and complements), Y income, T tastes and preferences, E expectations of future prices and income, N population, and A advertising. A demand schedule lists quantities at different prices; the demand curve graphs it.

A linear demand function has a constant slope. Take Q = 50 − 2.5P, and read it as a snack stall's plates sold per day at a price of ₹P (an illustration). Each ₹1 rise in price cuts sales by 2.5 plates, at every price.

Elasticity here is (ΔQ ÷ ΔP) × (P ÷ Q), with the minus sign ignored. ΔQ ÷ ΔP is 2.5 everywhere on this line, so only P ÷ Q changes. Elasticity falls as one moves down a straight demand line.

A non-linear demand function has a changing slope, such as Q = aP^−b. Its elasticity is constant at b, at every price.

Don't confuse slope with elasticity. Along the straight line above, the slope never changes, but elasticity (2.5 × P/Q) is 9 at P = 18 and 1.5 at P = 12. Slope compares raw changes; elasticity compares percentages.

Where it breaks. Firms estimate real demand functions from past data, usually by regression (see Demand forecasting). The estimates hold only while buyers, rivals and incomes stay much as they were.

For exams. Expect to substitute a price into a linear function, or to name each variable in D_x = f(P_x, P_r, Y, T, E, N, A).

When a sweet shop cuts its prices in a Diwali sale, the queue grows. Few rules in business are as reliable as this one.

Other things equal, when price falls quantity demanded rises, and when price rises it falls. "Other things equal" means that income, tastes, the prices of related goods and expectations stay as they were.

The table is an illustration of a demand schedule. Plot it, and the line falls from left to right.

Why the curve slopes downward.

• Income effect: a lower price raises real purchasing power, so buyers can afford more.
• Substitution effect: the good becomes cheaper relative to alternatives, so buyers switch towards it.
• Diminishing marginal utility: each extra unit is worth less to the buyer, so buyers pay less for more (see Utility analysis).

Textbooks often add two more reasons. At a lower price new buyers enter the market, and the good is put to more uses, as when cheaper electricity is used for cooling as well as light.

Don't confuse the law of demand with elasticity. The law gives only the direction: price up, quantity down. Elasticity, the next chapter, measures how far quantity moves.

Where it breaks. A few goods break the law (the next concept). In real sales data, other things are rarely equal, so a price cut and a shift in demand often arrive together.

For exams. Learn the three reasons. The income effect and the substitution effect together make up the price effect; indifference curve analysis is the usual tool for separating them.

Price down, quantity up, other things equal.

A jeweller raises the price of a limited range and sells more pieces, not fewer. A very poor family pays more for rice and ends up buying more rice. Both seem to break the law of demand.

Two further exceptions: speculative goods (a buyer who expects prices to rise buys more now) and necessities (demand is very inelastic, so a price rise barely cuts purchases). A high price can also be read as a sign of quality.

How a Giffen good works, an illustration. A very poor household must buy 10 meals' worth of food a day with ₹70. Rice costs ₹4 a meal; dal and vegetables cost ₹10 a meal. It buys 5 meals of each: ₹20 + ₹50 = ₹70.

Now rice rises to ₹5 a meal. The same 5 and 5 would cost ₹25 + ₹50 = ₹75, more than the household has. To still eat 10 meals, it gives up one meal of dal and buys 6 of rice: ₹30 + ₹40 = ₹70. Rice became dearer, and the household bought more of it.

A Giffen good needs three conditions together: it is strongly inferior, it takes a large share of the budget, and it has no close substitute. Then a price rise makes buyers so much poorer that they buy more of it. Marshall named the case after Sir Robert Giffen, who is credited with observing it among poor households. Veblen described conspicuous consumption in The Theory of the Leisure Class (1899). Harvey Leibenstein named the bandwagon, snob and Veblen effects in a 1950 paper.

Don't confuse a Giffen good with a Veblen good. A Giffen good is a cheap staple of the poor, driven by the income effect. A Veblen good is a luxury of the rich, driven by status. Every Giffen good is inferior, but most inferior goods are not Giffen goods.

Where it breaks. Several items on the list are not true exceptions. With necessities, quantity still falls a little: the curve is steep, not upward-sloping. With speculation, expectations have changed, so the curve has shifted. Bandwagon and snob effects mainly change how strongly market demand reacts to price. Real Giffen goods are rare. Robert Jensen and Nolan Miller (2008) found evidence of Giffen behaviour for rice among very poor households in Hunan, China, in a field experiment that subsidised rice.

For exams. Match each effect to its idea and example. For Giffen goods, remember the three conditions and the income effect; for Veblen goods, status and The Theory of the Leisure Class.

Veblen: status. Giffen: staple. Snob: exclusive. Bandwagon: follow.

A Pune firm makes brake pads. Nobody wants brake pads for their own sake: its sales rise and fall with the car market. Knowing what kind of demand a firm faces tells it what to watch.

Market demand, worked, an illustration. At ₹60 a litre, three families buy 2, 1 and 3 litres of milk a day. Market demand at that price is 2 + 1 + 3 = 6 litres. Repeat at every price and you have the market demand curve.

The brake-pad maker faces several types at once. Its demand is derived from car sales. Part of it is replacement demand from cars already on the road. Its own sales are firm demand; all brake-pad makers together make up industry demand.

Don't confuse joint demand with composite demand. Joint demand is two goods wanted together for one purpose (a car and petrol). Composite demand is one good wanted for several purposes (electricity for lights, fans and machines).

Where it breaks. The types overlap. Electricity is composite demand, and for a factory it is also derived demand. Few goods are truly independent of all others.

In practice. A firm facing derived demand watches its customers' markets, not only its own. A firm selling durables watches the age of goods already in use, because replacements make up part of its sales.

For exams. Expect to match an example to its type: car and petrol is joint, electricity composite, steel for cars derived, salt independent.

A cement dealer must order stock months before the building season. Order too little and customers go to a rival; order too much and cash sits in the godown. A forecast of demand is what the order rests on.

In the short run it guides production, pricing, sales targets and working finance. In the long run it guides capacity, investment and manpower planning.

Steps: set the objective, fix the period, choose a method, collect primary or secondary data, then estimate and interpret.

A trend projection, worked, an illustration. The cement dealer sold 40, 44, 50, 54 and 62 thousand bags in five years. Number the years T = −2, −1, 0, 1, 2, so that they add to zero.

Here ΣTY = (−2 × 40) + (−1 × 44) + 0 + (1 × 54) + (2 × 62) = −80 − 44 + 54 + 124 = 54. And ΣT² = 4 + 1 + 0 + 1 + 4 = 10. The trend is Y = 50 + 5.4T. Next year is T = 3, so the forecast is 50 + 5.4 × 3 = 66.2 thousand bags.

Survey methods suit new products and the short run; statistical methods suit established products with long sales records. No method is free of error, so forecasts are often cross-checked.

Don't confuse a forecast with a sales target. A forecast estimates what will sell. A target states what management wants sold. Setting the forecast equal to the target hides the gap that management needs to see.

Where it breaks. Every statistical method assumes the future resembles the past. A new rival, a change in policy or a sudden shock breaks the pattern, and the trend line will not see it coming.

In practice. Forecast a range, not a single number, and record each forecast so its error can be measured later.