Foundation Paper 4 Fundamentals of Business Economics and Management Study Notes PDF

FOUNDATION Paper 4 FUNDAMENTALS OF BUSINESS ECONOMICS AND MANAGEMENT Study Notes SYLLABUS 2022 The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in First Ed...

FOUNDATION Paper 4 FUNDAMENTALS OF BUSINESS ECONOMICS AND MANAGEMENT Study Notes SYLLABUS 2022 The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in First Edition : August 2022 Reprint : November 2022 Reprint : February 2023 Reprint : March 2023 Reprint : June 2023 Reprint : August 2023 Reprint : September 2023 Reprint : February 2024 Reprint : April 2024 Revised Edition : July 2024 Price: ` 400.00 Published by : Directorate of Studies The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 [email protected] Printed at : M/s. Print Plus Pvt. Ltd. 212, Swastik Chambers S. T. Road, Chembur Mumbai - 400 071 Copyright of these Study Notes is reserved by the Institute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof. Copyright © 2024 by The Institute of Cost Accountants of India  PAPER 4 : FUNDAMENTALS OF BUSINESS ECONOMICS AND MANAGEMENT Syllabus Structure: The syllabus in this paper comprises the following topics and study weightage: Module No. Module Description Weight Section A: Fundamentals of Business Economics 70% 1 Basic Concepts 15% 2 Forms of Market 20% 3 Money and Banking 20% 4 Economic and Business Environment 15% Section B: Fundamentals of Management 30% 5 Fundamentals of Management 30% Contents as per Syllabus SECTION A : FUNDAMENTALS OF BUSINESS ECONOMICS 01 - 176 Module 1. Basic Concepts 01 - 88 1.1 The Fundamentals of Economics 1.2 Utility, Wealth, Production 1.3 Theory of Demand (meaning, determinants of demand, law of demand, elasticity of demand-price, income and cross elasticity, theory of consumer behaviour, demand forecasting) and Supply (meaning, determinants, law of supply and elasticity of supply), Equilibrium 1.4 Theory of Production (meaning, factors, laws of production-law of variable proportion, laws of returns to scale) 1.5 Cost of Production (concept of costs, short-run and long-run costs, average and marginal costs, total, fixed and variable costs) 1.6 Means of Production Module 2. Forms of Market 89 - 114 2.1 Pricing of Products and Services in various Forms of Markets – Perfect Competition, Duopoly, Oligopoly, Monopoly, Monopolistic Competition 2.2 Price Discrimination Module 3. Money and Banking 115 - 158 3.1 Money - Types, Features and Functions 3.2 Banking - Definition, Functions, Utility, Principles 3.3 Commercial Banks, Central Bank 3.4 Measures of Credit Control and Money Market  Contents as per Syllabus Module 4. Economic and Business Environment 159 - 176 4.1 PESTEL (Political, Economic, Societal, Technological, Environmental and Legal) Analyses 4.2 Emerging Dimensions of VUCAFU (Volatility, Uncertainty, Complexity, Ambiguity, Fear of Unknown and Unprecedentedness) SECTION B – FUNDAMENTALS OF MANAGEMENT 177 - 328 Module 5. Fundamentals of Management 179 - 328 5.1 Introduction to Management 5.2 Stewardship Theory and Agency Theory of Management 5.3 Planning, Organizing, Staffing and Leading 5.4 Communication, Coordination, Collaboration, Monitoring and Control 5.5 Organisation Structure, Responsibility, Accountability and Delegation of Authority 5.6 Leadership and Motivation – Concepts and Theories 5.7 Decision-making – Types and Process  SECTION - A FUNDAMENTALS OF BUSINESS ECONOMICS  Basic Concepts BASIC CONCEPTS 1 This Module includes: 1.1 The Fundamentals of Economics 1.2 Utility, Wealth and Production 1.3 Theory of Demand (meaning, determinants of demand, law of demand, elasticity of demand-price, income and cross elasticity, theory of consumer behaviour, demand forecasting) and Supply (meaning, determinants, law of supply and elasticity of supply), Equilibrium 1.4 Theory of Production (meaning, factors, laws of production-law of variable proportion, laws of returns to scale) 1.5 Cost of Production (concept of costs, short-run and long-run costs, average and marginal costs, total, fixed and variable costs) 1.6 Means of Production The Institute of Cost Accountants of India 1 Fundamentals of Business Economics and Management BASIC CONCEPTS Module Learning Objectives: After studying this Module, the students will be able to –  Develop an understanding of the fundamental concepts of Economics such as consumer’s behaviour, producer’s behaviour, utility, wealth and output generation.  Attain in-depth knowledge of the law of demand and supply, concept of elasticity, equilibrium price and techniques of demand forecasting to facilitate marketing function in an organization.  Appreciate the factors of production, law of variable proportion and law of returns to scale in the short term and long-term production planning respectively.  Develop detail understanding of short run and long run behavior of total and average cost and their impact in managerial decisions.  Acquire knowledge of various means of production. 2 The Institute of Cost Accountants of India  Basic Concepts Introduction 1 I n this module, we will focus mainly on the demand analysis and cost analysis. This is because the business firms should have a clear idea of the market of its product through these two analyses. Demand analysis determines the sales prospect of the business. So it has two important purposes (i) forecasting of sales and (ii) manipulation of demand. Production plans, inventory plans, investment plans, cash budgets, expansion of the firm – all depend on the volume of sales. Particularly this is important for a business firm which has seasonal fluctuations in its product demand. Again, sales depend on advertisement, price policy, product improvement plans. Since these are within the control of the business firm, demand can be manipulated. The cost analysis is important for the business firm because the estimation of cost is crucial for the firm to plan out production, investment and finally the plant size. For cost estimation, the firm can use multiple regression analysis by using the equation C = a + bX1 + cX2 + u Where, C is total cost of production, X1 is the level of output and X2 is the plant size, and U is the factor which captures the effects of other omitted variables explaining cost of production. By estimating the three parameters a, b, and c, we can estimate the change in C per unit change in one independent variable (say, X1), when the other independent variable (X2) is held constant. The Institute of Cost Accountants of India 3 Fundamentals of Business Economics and Management The Fundamentals of Economics 1.1 What is Economics? Economics is one of the social sciences. It explains about the economic activities of a man. Any activity which is related to earning of the money and spending of the money is called economic activity. Almost all people are engaged in economic activities, because they want to earn the money. The main economic problem is to transform society’s resources into consumable commodities by using productive technology. It is a problem because human wants are unlimited and society’s resources are limited. So the central task of economics is to decide how much of which commodities are to be produced for the optimum satisfaction of human wants. The firms and the households are the basic economic entities in an economy. The firms are the “production units” and households are the “consumption units”. These firms buy different factors of production such as machines, labour, raw materials etc., and produce and sell different types of products and services. The main aim of these firms is to maximise their profits. The households, on the other hand, try to maximise their satisfaction from their consumption of the goods produced by the firms. Subject Matter of Economics: In economics, a want is something that is desired. But all desires are not economic wants. The desires, which are achievable and are covered by purchasing power, are economic wants. Such wants give rise to efforts and thereby economic activity. If one wants to go to the moon, that cannot be construed as economic want as it is not covered by purchasing power. Want is the starting point of economic activity. Wants leads to efforts. An effort leads to satisfaction. Wants Efforts Satisfaction. This is the subject matter of economics. This subject matter of economics is divided into four parts. (i) Consumption (ii) Production (iii) Exchange (iv) Distribution (i) Consumption: It is an act to use the goods or service to satisfy the wants. In Economics, Consumption is typically defined as final purchase by an individual that are not investments of some sort. In other words, when you buy food, clothes, airplane tickets, a car, etc., that’s consumption. 4 The Institute of Cost Accountants of India  Basic Concepts Through consumption the consumer destroys the utility of the commodity. This utility was created by the producer through production. If someone buys a house to live in, that should be defined as consumption. If they buy a house to rent out it to someone else, that should be defined as an investment. Similarly, if they buy a car to drive, that’s consumption. If you buy a car to use as a taxi for a business, that could be construed as an investment. In short the reason for the purchase determines whether something is viewed as an investment or as consumption. (ii) Production: In economics, Production involves the creation of goods and services by using resources. It is a process to change the raw materials into final/finished goods. It is nothing but creation of utility. To produce anything so many factors are essential. All these factors are classified into four categories. They are: (a) Land (b) Labour (c) Capital (d) Organization (iii) Exchange: When two individuals bring their products for trading purposes in the market, such act is called exchange when trading is complete. In olden days, goods were exchanged for goods under the “Barter system”. But this system is inconvenient. Suppose, X has got cow and Y has got rice for exchange. X wants rice but Y does not want cow. So trade will not take place. Again, if one cow is exchanged for 4 Kg of rice and Y has got only 2 Kg of rice, exchange cannot take place as 2 Kg of rice cannot be exchanged for half a cow. With the introduction of money these difficulties have been smoothed out. (iv) Distribution: Distribution means sharing of the income among the factors of production. The total income which is generated by selling of these goods and services in the market must be distributed among the factors of production in the form of rent, wages, interest and profits. There are two types of distributions 1. Micro distribution 2. Macro distribution 1. Micro Distribution Micro distribution is nothing but pricing of factors of production. It means it explains how the price (rent) per unit of land is determined. In the same way how the price per unit of labour (wages) and capital (rate of interest), etc. is determined are discussed in this head. Ricardian theory of rent, modern theory of rent, different wage theories, interest theories, profit theories, etc are discussed. 2. Macro Distribution Macro distribution means sharing of the total national income among the total factors of production. It means we will come to know whether the income is distributed properly or not properly among the people in the society. Modern economists extended the subject matter of economics. They added some other concepts to the different dimensions of economics. They are: (a) Employment (b) Income (c) Planning and Economic development (d) International trade The Institute of Cost Accountants of India 5 Fundamentals of Business Economics and Management 1.1.1 Definitions of Economics: The definitions of economics can be classified into four categories. (a) Wealth definition (b) Welfare definition (c) Scarcity definition (d) Growth definition (a) Wealth definitions: Almost all the classical economists followed wealth definitions. It is mostly associated with J.B. Say and Adam Smith. Adam Smith was called “Father of Economics”. The name of the book written by Adam Smith is “An Enquiry into the Nature and Causes of Wealth of Nations” (1776). Adam Smith delinked the economics from political economy and he explained it in a scientific manner. Definitions: According to J. B. Say, “Economics is the study of science of wealth. According to Adam Smith, “Economics is the science which deals with the wealth”. According to the above definitions:-  Economics explains how the wealth is produced, consumed, exchanged and distributed.  According to Adam Smith man is an economic man.  Economics is a science of study of wealth only.  This definition deals with the causes behind the creation of wealth.  It only considers material wealth. Criticism: This definition was criticized by so many philosophers. They are Carlyle, Ruskin, Walras, and Dickens and others. According to critics, economics is a decimal science, Gospel of Mammon, bread and butter science, incompleted science etc. Wealth is of no use unless it satisfies human wants. This definition is not of much importance to man and his welfare. (b) Welfare definition: This definition was given by Alfred Marshall. He was the follower of Adam Smith. He wrote a famous book “Principles of Economics” (or) “Principles of Political Economy” in 1870. Definition: “Economics is the study of mankind in 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 material requisites of well being”. According to Alfred Marshall’s definition, economics is one side study of wealth, on the other and more 6 The Institute of Cost Accountants of India  Basic Concepts important side, a part of the study of man (or) welfare of the man. Main Points: 1. According to this definition, economics is a social science. 2. According to the definition, goods are classified into two types (or) categories: - Material goods - Immaterial goods 3. According to Alfred Marshall, economics is a normal science. 4. The top priority is given to man (or) welfare of man, secondary priority is given to wealth. 5. Marshall enhanced the status of man from economic man to social man. Economics related only some material goods which promote the human welfare. Criticism: This definition was criticized by Lionel Robbins on the following grounds: 1. According to Robbins, welfare definition is an incomplete definition. 2. According to Robbins, economics must be neutral between ends. 3. Marshall neglected some materials goods which do not promote human welfare, but these goods are also produced; exchanged & consumed. So, they also come under the subject matter of economics. Example: Cigarette and alcoholic products. (c) Scarcity Definition/Robbins definitions: This definition was given by Lionel Robbins. He wrote a famous book “An Essay on the Nature and Significance of Economic Science” (1932). Definitions: “Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses”. - Robbins Main Points: In the above definition: 1. Wants are unlimited 2. Limited resources 3. Alternative uses of limited resources 4. Problem of choice Merits: 1. According to this definition economics is an analytical science. 2. Economics turns into universal science. 3. According to Robbins, it is a positive science. 4. Neutral between ends. The Institute of Cost Accountants of India 7 Fundamentals of Business Economics and Management Criticism: These definitions was also criticized by so many economists on the following terms: 1. It is not a universal science. 2. Not applicable to developed countries. 3. Not applicable to communist (or) dictatorship countries. 4. It is not applicable to developing countries like India. 5. It is an old wine in a new bottle. 6. It also neglected the dynamic concepts. (d) Growth Definition This Definition was given by J.M. Keynes and P.A. Samuelson in the book written by Samuelson “Economics - An Introductory Analysis”, (1948). In this book, he gave a new definition to economics. Definitions “Economic is the study of how men and society choose with ‘or’ without use of money to employ the scarce productive resources that would have alternative uses to produce various commodities over time for distributing them for consumption now or in future among the various persons and groups in the society. It analyses the costs and benefits of improving pattern or resource [use allocation]. - P.A. Samuelson Main points: 1. Like the scarcity definition, it also accepts the unlimited wants and limited resource which have alternative uses. 2. According to Samuelson, the problem of scarcity of resources not only confined to present but also to the future. It means he introduced the concept of time element. 3. He also adopted a dynamic approach to the study of economics considering economic growth as an integral part of economics. 4. This definition includes Marshall’s welfare definition and Robbin’s scarcity definition. 1.1.2 Micro and Macro Economics The term ‘Micro’ and ‘Macro’ were introduced by Ragnar Frisch in Economics. He is the Prof. of Oslo University in Britain. According to him, economics is studied in two ways i.e., Micro level and Macro level. Meaning of Micro Economics: The word Micro is derived from the Greek work ‘Mikros’, means ‘very small or millionth part’. It studies about the behavior of individual units. Individual units are a consumer, a producer, a firm or industry. Marshall developed the Micro economics very well. According to Marshall, the Micro economics divide the economy into small units or small parts and each part is studied. It explains how a consumer gets maximum satisfaction, how the producer gets maximum output and how the firm gets maximum profit. Definition: Micro economics is the study of “particular firm particular household, individual prices, wages, incomes, individual Industries, particular commodities”. - K. E. Boulding 8 The Institute of Cost Accountants of India  Basic Concepts Scope of Micro Economics: The Micro economics explains how the price of a good is determined and how the price per unit of factors of production is determined and it also deals with theories of economic welfare. So Micro economics is called “Price theory”. Scope of Micro Economics Theory of Product Pricing Theory of Factor Pricing Theory of Economic Welfare Demand Analysis Rent Efficiency in Production Supply Analysis Wages Efficiency in Consumption Interest Overall Economic Efficiency Profit Figure: 1.1 Scope of Micro Economics Uses or Significance of Micro Economics: 1. Understanding the operations of economy 2. Economic welfare of people 3. Managerial economics Macro Economics: The word “Macro” is derived from Greek word “Makros”, means “large or very big”. The Macro economics studies the economy as a single unit. It does not deal with individual units. It deals with the aggregates ‘or’ totals and averages. For example: National Income, full employment, total output, total investment, total consumption etc. Definition: According to Gardner Ackley, “Macro economics is concerned with such variables as an aggregate volume of output of a economy with the extend to this resources are employed with the size of the national Income and with the general price level”. Scope of Macro Economics: Macro economics studies about the National Income i.e. calculation of the national income, trends in the national income etc., It also deals with total employment (full employment), total output etc., It also studies about trade cycles, Inflation etc., It also deals with theories of economic growth and macro theory of distribution. It is also called Income and Employment theory. The Institute of Cost Accountants of India 9 Fundamentals of Business Economics and Management Both Micro and Macro Economics are interdependent. From 1930 onwards there is an importance to the Macro economics. Scope of Macro economics can be explained by the following chart. Scope of Macro Economics Theory of Output Theory of Trade Theory of Theory of Micro Theory of and Employment Cycles Inflation Economcs Growth Distribution Consumption Investment Figure: 1.2 Scope of Macro Economics The Macro economics analyses some problems of the economy: 1. Level of output and employment. 2. Fluctuation in level of output, employment and National Income. 3. Changes in the general price level. 4. Economic growth and economic development. 5. Theories of distribution. Significance of Macro economics: 1. Understanding the working of an economy 2. Formulating policies 3. Preparations of the economics plans 4. Taking the remedial measures of trade cycles & Inflation Is Economics - An Art or Science Meaning of Science: The term science implies:- 1. A systematic body of knowledge which traces the relationship between cause and effect. 2. Observation of certain facts, systematic collection and classification and analysis of facts 3. Making generalization on the basis of relevant facts and formulating laws or theories there by. 4. Subjecting in the theories to the test of real world observations. Like the subjects, physics, chemistry botany and economics also satisfies the above four characteristics. Hence, Economics is regard as science. 10 The Institute of Cost Accountants of India  Basic Concepts Economics as an Art: Keynes defines Art as ‘a system of rules for the attainment of a given end”. The object of Art is to formulate rules to be used for the formulation of policies. Difference between Science and Art: 1. Science is theoretical but art is practical. 2. Science teaches us “to know”, an Art teaches us “to do”. 3. Economics is science in its methodology and Art in its application. Hence, economics is considered as both Science as well as Art. Is Economics Positive Science ‘or’ Normative Science? Economics as a positive science: 1. The positive science explains “what it is” but not “what ought to be” 2. It explains about the things as they are 3. It does not deal with value judgments. 4. According to Lionel Robbins Economics is a Positive Science. Economics as a Normative Science: 1. A normative science explains what ought to be and what not ought to be. 2. It does relate to value judgments 3. It deals with good & bad (or) right and wrong. 4. According to Alfred Marshall Economics is a Normative Science. Note: Hence, economics is considered as both positive & normative science. Deductive Method and Inductive Method Conclusion (Deductive method is a static analysis and Inductive method is dynamic.) Deductive Method: 1. It is also called prior method, abstract method and analytical method. 2. In this method the laws or theories are prepared on the basis of fundamental assumptions. 3. In this method the logic proceeds from general to particulars. For example: law of D.M.U, law of equi-marginal utility, law of consumer surplus etc. 4. Classical economists followed deductive method. Inductive Method: 1. This method is also known as historical method ‘or’ statistical method. The Institute of Cost Accountants of India 11 Fundamentals of Business Economics and Management 2. In this method, the laws ‘or’ theories are prepared on the basis of facts ‘or’ statistical data. 3. In this method, the logic proceeds from particular to general. For example: law of variable proportions, law of returns to scale, population theories etc. 4. Modern economist followed Inductive method. Central Problems of All Economies Due to the scarcity of resources, every economy faces problems. The central problems of all economics are explained as follows: What to produce? An economy should produce something on the basis of the requirements of the society. Further, if the present is given importance the resources are diverted for the production of consumer goods. If future is given importance the resources are diverted for the production of capital goods. How to produce? This problem is arising because of unavailability of some resources. A country may produce by labour intensive technique ‘or’ capital Intensive technique, depending upon its man power and stock of capital. For whom to produce? Government policy determines what are the commodities to be produced and for whom. One can make a conjecture from the pattern of production of the country. If the government decides to produce more ordinary buses than luxury cars then one can understand that the country is producing for the poor and not for the rich. 12 The Institute of Cost Accountants of India  Basic Concepts Utility, Wealth and Production 1.2 1.2.1 Utility Utility is a measure by which a consumers scale of preference on a good or service is quantified. Production, on the other hand is the quantity obtained from the use of the efficient combinations of the different factors/inputs. In the later part we will come to these two concepts in detailed. Now we discuss on Wealth 1.2.2 Wealth The stock of goods under the ownership of a person ‘or’ a nation is called wealth. (a) Personal wealth: The stock of goods under the ownership of a person is called personal wealth. For example: Houses, buildings, furniture, land, money in cash, company shares, stocks of other commodities etc., health, goodwill etc. can also be considered to be the parts of Individual wealth. But in economics, only transferable goods are considered as wealth. (b) National Wealth: The stock of goods under the ownership of a nation is called national wealth. It includes the wealth (common property) of all the citizens in the country. For example: Natural resources, roads, parks, bridges, hospitals, public education institutions etc., If the citizen of the country holds a government bond it is personal wealth. But from the Government point of view, it is a liability. So, it should not be considered as the part of wealth of nation. Wealth and Welfare: Welfare means well-being ‘or’ happiness. Generally, if the level of wealth increases, welfare also increases but: 1. It is doubtful whether the welfare increases if a nation goes on creating wealth without paying any consideration to the health and mental peace of citizens, whether welfare increases. 2. It is doubtful if the wealth is not distributed properly. Wealth and Income: A person (‘or’ a Nation) consumes a part of income and saves the rest. These savings are accumulated in the form of wealth. Wealth is a stock owned at a point of time. Income is a flow, over a period of time. 1.2.3 Production It refers to creation of goods for the purpose of selling them into the market. In one word, production means The Institute of Cost Accountants of India 13 Fundamentals of Business Economics and Management ‘Creation of utility”. When a child make a doll for playing for her enjoyment, it is not called production but the doll maker who sells these dolls in the market is engaged in production. Factors of production: The goods and services with the help of which the process of production is carried out are called factors of production. The total factor of production are the following: 1. Land 2. Labour 3. Capital 4. Organization The factors of production are also called Inputs. The goods and services produced with the help of Inputs are called output. Production Possibility Curve (PPC): The PPC is also called Production Possibility Frontier, Production Possibility Boundary and Production Transformation Curve. The PPC curve shows the various combinations of two commodities that can be produced by an economy with the given resources and given technology. Figure: 1.3 Production Possibility Curve Main points: 1. The PPC curve always slopes downwards form left to right. Because when the production of one commodity is increased the production of another commodity will be foregone. This is due to resource constraint of the economy. 2. The slope of the PPC at any given point is called Marginal rate of transformation (MRT). The slope defines the rate at which production of one good can be redirected into production of other. It is also called opportunity cost. 3. It is concave to the origin because Marginal rate of Transformation (MRT) goes on increasing. Suppose, we are on the point D of the left hand diagram of fig.1.2. If we now try to move to the right, we are 14 The Institute of Cost Accountants of India  Basic Concepts in fact throwing away guns and taking butter instead. There are some specialised input which are meant for gun factory will be useless in the butter factory. So, gradually more and more inputs will become unemployed. Hence, the sacrifice of the same number of guns will yield less and less amount of butter as we move to the right and this will result in a concave curve. In other words, the Marginal Rate of Transformation will be falling. Note:  If the PPC curve is straight line, the opportunity cost is constant.  All the combinations which lie on the PPC curve are possible combinations.  The points beyond the PPC curve are impossible combinations.  Shift of the PPC curve is nothing but economic growth.  Any point which lies below the PPC curve is possible combination. But if the economy is working below the PPC curve that indicates the unused resources ‘or’ unemployment. (i) Money: Anything which is widely accepted in exchange of goods or in settling debts is regarded as money. Barter system existed before the introduction of money. Under barter system, goods are exchanged for goods. For example, 1 kg of rice is exchanged for 2 kg of wheat. But if 2 goats are exchanged for 1 cow, the problem of indivisibility crops up. 1 goat cannot be exchanged for ½ a cow. So, barter system was replaced by the monetary system. When some commodities are used as a medium of exchange by customs, it is called customary money. For example: The use of cowries in ancient India as a medium of exchange. Constituents of Money Supply: 1. Rupee notes and coins 2. Credit cards 3. Traveler’s cheques (ii) Income: The net inflow of money (purchasing power) of a person over a certain period of time is called income For example: Daily income, weekly income, monthly income and yearly income. (iii) Saving: Saving is defined as income minus consumption. Whatever is left in the hands of an individual after meeting the consumption expenditure is called saving. Saving is generated out of current income and also out of past income. (iv) Market: In ordinary language, the term market refers to a place where the goods are bought and sold. But in economics it refers to a system by which the buyers and sellers establish contact with each other directly ‘or’ indirectly with a view to purchasing and selling the commodity. Function of the Market: The Institute of Cost Accountants of India 15 Fundamentals of Business Economics and Management a. To determine the price of the goods. b. To determine the quantity of goods [supply] Market Mechanism: Market Mechanism means the totality of all markets i.e. the markets for all goods & services in the economy. The market mechanism determines the prices and quantities brought and sold of all the goods and services. (v) Capital Stock and Investment: Investment is the increment in capital stock. Suppose, we have a reservoir filled with water and there is a tap over the reservoir. If the tap is turned on, water will flow in the reservoir and the water level in the reservoir will increase. If we are permitted to draw analogy, then, water in the reservoir can be compared to the capital stock and the water-flow from the tap can be compared with the investment. Capital stock indicates the productive capacity of the economy. Suppose, with 100 machines the economy can produce at the maximum 1,00,000 units of output. Here, 100 machines represent the capital stock and 1,00,000 units of output represent productive capacity. If the economy decides to increase the level of output, it has to produce new machines. Producing new machines is called capital formation or investment. If through out the year 50 machines are produced, then these 50 machines will be the investment for the economy. The economy can start production with 150 (100 + 50 ) machines as the new capital stock in the next year. Types of Investment: (a) Real Investment: An increase in the real capital stock is called real investment. For example machines, raw material, buildings and other types of capital goods. (b) Portfolio Investment: The purchasing of new shares of a company is called portfolio investment. Note: Purchasing of an existing share from another share holder is not an investment. Because it cannot increase the capital stock of the company. It is the savings that are invested: In the product market in the macroeconomic frame work, equilibrium will be established when the following equation holds. Y=C+I Where, Y is the National Income (or, output), C is Consumption demand and I is Investment demand. The right hand side of the equation is aggregate demand and the left hand side of the equation is aggregate supply. In equilibrium, aggregate demand is exactly equal to aggregate supply. Aggregate supply or, National Income can be sub-divided into two parts, namely, consumption and savings (C + S). Therefore, equilibrium equation will now be as follows: C+S=C+I Or, S=I So, in equilibrium, savings is equal to investment. But there is no guarantee that these two should always be equal. This is because savings are made by the households while investments are undertaken by the businessmen. Their motives are completely different. 16 The Institute of Cost Accountants of India  Basic Concepts  Note: If there is foreign investment then S ≠ I. Gross Investment and Net Investment: The Aggregate Investment made by an economy during a year is called gross investment. The gross investment includes: (a) Inventory Investment: Investment in raw materials, semi finished goods and finished goods are called inventory investment. (b) Fixed Investment: Investment made in fixed assets like machines, building, factories shares etc. is called fixed investment. Net Investment: By deducting the depreciation cost of capital from gross investment, the net investment can be obtained. Net Investment = Gross Investment – Depreciation The Institute of Cost Accountants of India 17 Fundamentals of Business Economics and Management Theory of Demand, Supply and Equilibrium 1.3 1.3.1 Demand Meaning of Demand Demand means ‘desire in common parlance’. But in economics demand means desire backed by the purchasing power and willingness to pay the price. Demand is basically a purchase of any good or service which involves the expositions of the desire by the demander, the customer, and the ability of the demander. Ability or purchasing power is measured usually by the level of income and wealth of the customer. For example, a student demands for a book on Managerial Economics by a particular author. Though he has the desire to take and read the book but he may not purchase the book because he may not have that much of money. Hence to complete demand for a good or service there should be the combinations of desire and purchasing power. In the following discussions we will be covering details on the topic of theory of demand. Determinants of demand: The demand for any commodity depends upon so many factors. These factors are called determinants of demand. They are: 1. Price of the goods: The demand for any commodity firstly depends upon its own price. When the price rises demand decreases, and when the prices falls demand increases. 2. Prices of the substitute goods: The demand for any commodity not only depends upon its own price but also the prices of its substitute goods. For example, tea and coffee. Here the demand for tea depends upon price of the coffee. If the price of coffee falls, the demand for coffee will rise following the law of demand. Since coffee is the substitute for tea, people will reduce the consumption of tea and increase the consumption of coffee, as coffee is now relatively cheaper than tea. So, when the price of coffee falls, the demand for tea will also fall. The essence of this example is that demand for a commodity, Dn and the price of its substitute, Ps are directly or positively related. 3. Prices of the complementary goods: The demand for a commodity also depends upon the price of its complementary goods. For example, car and petrol. Here the demand for petrol depends upon price of the car. If the price of petrol rises, the demand for petrol will fall, following the law of demand. Since petrol is complementary to the car, people will reduce the demand for car along with petrol. So, when the price of petrol rises, the demand for car will fall. This analysis indicates that the demand for a commodity, Dn and the price of its complement, Pc are inversely related. 18 The Institute of Cost Accountants of India  Basic Concepts 4. Income of the consumer: The income of the consumer also influences the demand for a commodity. When the income rises people purchase the more quantity of goods. When the income falls they purchase less quantity of goods. This happens when the good is normal. But the reverse relation will work when the good will be inferior. 5. Tastes and preferences of the consumer: The tastes and preferences of the consumer can also determine the demand for a commodity. When the tastes are changed, the demand for goods are also changed. 6. Population: When the population size increases, the demand for goods also increases. When the population decreases demand also decreases. 7. Climate: The climatic conditions also can influence the demand. In hot climatic conditions, cold drinks are demanded. In rainy season, the demand of umbrellas are increased. Law of Demand The law of demand is a general statement stating that price and quantity demanded of a commodity are inversely related. Demand Function: Demand function explains the functional relationship between price and quantity demanded. According to the law of demand, when all other things remain constant, if the price of the good rises then its demand is decreased. If the price falls, demand will be increased. It means there is an inverse relationship between price and change in demand/ change in price is negative in sign. Dx = f [Px] The demand function explains the functional relationship between demand for a commodity and determinants of the demands. This can be explained by the following equation: Dn = f [ Pn, Ps, Pc, Y, T ] Where, Dn = Demand for commodity ‘n’ f = functional relationship Pn = Price of commodity ‘n’ Ps = Price of the substitute Pc = Price of the complement Y = Income of the consumer T = Taste and preference of the consumer Demand Schedule: It shows the various quantities of the goods that are demanded at various levels of prices. There are two types of demand schedules: 1. Individual Demand Schedule The Institute of Cost Accountants of India 19 Fundamentals of Business Economics and Management 2. Market Demand Schedule. 1. Individual Demand Schedule: It shows the various quantities of a particular good that are demanded by an individual at various levels of prices in the market. Price Demand 5 10 4 20 3 30 2 40 1 50 Individual Demand Curve: From the demand schedule we can derive demand curve Figure: 1.4 Individual Demand Curve 2. Market Demand Schedule: It shows the various quantities of the goods that are demanded by all the consumers (A, B, C.... say) in the market at various levels of prices in the market. When the individual demands are added, market demand then be obtained. Price of Good ‘x’ Demand A B C Demand (A+B+C) 10 100 150 50 300 8 125 200 60 385 6 175 250 80 505 4 250 300 110 660 2 350 400 150 900 20 The Institute of Cost Accountants of India  Basic Concepts Figure: 1.5 Market Demand Curve The individual demand curve or market demand curve slopes downwards from left to right because there is an inverse relationship between price and demand. Causes for falling nature of Demand Curve i.e. downward sloping demand curve: There are many reasons for the falling nature of demand curve. Some of the reasons are explained as follows: 1. Law of diminishing marginal utility: According to law of diminishing marginal utility when the quantity of goods is more the marginal utility of the commodity will be less. So, the consumer demands more goods when the price is less. That is why, the demand curve slopes downwards from left to right. 2. Substitution effect: In the case of substitutes, if the price of commodity ‘x’ rises relatively to the other good ‘y’ the consumer will buy less of commodity ‘x’ and buy more of the good ‘y’ which has become relatively cheaper. This is called substitution effect. So the demand curve slopes downward. 3. Income effect: The income effect tells that the real income of the consumer rises due to the fall in the price level. So they purchase more and more goods when the price falls. This is said to be the income effect. 4. New buyers: When the price of a commodity decreases, the new consumers are attracted to that commodity because when the price level falls it becomes cheaper good than before. So, the demand will rise when the price falls. 5. Old buyers: When the price of anything decreases the old buyers purchase more goods than before. So the demand will be increased. That is why, the demand curve slopes downward from left to right. Exceptions to the Law of Demand: The law of demand is a general statement stating that price and quantity demanded of a commodity are inversely related. But in certain situations, more will be demanded at a higher price and less will be demanded at a lower price. In such cases, the demand curve slopes upward from left to right which is called an exceptional demand curve as shown in the following diagram. The Institute of Cost Accountants of India 21 Fundamentals of Business Economics and Management Figure: 1.6 Quantity Demanded When price increases from OP to OP1, quantity demanded also increases from OQ to OQ1. This is contrary to the Law of Demand. The following are the exceptions to the Law of Demand. 1. Giffen Paradox (Necessary goods): In the case of necessary goods, the law of demand cannot be operated. This is observed by British Economist, Sir Robert Giffen. He observed in London the low paid workers purchases more of bread when its price rises. That’s why, this situation is known as Giffen Paradox. 2. Speculation: Some times the price of a commodity might be increasing and it is expected to increase further. The consumers will buy more of the commodity at the higher price than they did at the lower price. It is contrary to law of demand. 3. Conspicuous: These are certain goods which are purchased to project the status and prestige of the consumer e.g., expensive cars, diamond jewellery, etc. Such goods will be purchased more at a higher price and less at a lower price. 4. Shares or Speculative market: It is found that people buy shares of a company whose price is rising on the anticipation that the price will rise further. On the other hand, they buy less shares in case the prices are falling as they expect a further fall in price of such shares. Here, the law of demand fails to apply. 5. Bandwagon effect: Here the consumer demand of a commodity is affected by the taste and preference of the social class to which he belongs to. If playing golf is fashionable among corporate executive, then the price of golf accessories rises, the business man may increase the demand for such goods to project his position in the society. 6. Veblen Effect: Sometimes, consumers develop a false idea that high priced goods will have a better quality instead of a low priced good. If the price of such a good falls, they feel that its quality also deteriorates and they do not buy, which is contrary to the law of demand. It is also known as Veblen Effect. 22 The Institute of Cost Accountants of India  Basic Concepts Types of Demand: There are three types of demands. They are: 1. Price demand 2. Income demand 3. Cross demand 1. Price Demand: Price demand explains the relationship between price of a commodity and demand for that commodity. There is an inverse relationship between price and demand. So, the price demand curve slopes downwards from left to right. Dx = f [Px] Fig: 1.7 Demand Curve – Price-Quantity Relationship 2. Income Demand: Income demand explains the functional relationship between income of consumer and demand for goods. Generally, if the level of income rises, the consumer purchases more goods. If the level of income decreases he purchases less quantity of goods. It means there is a direct proportional relationship between income of consumer and demand of goods. So, normally the income demand curve slopes upwards form left to right. Dx = f [y] The income demand curve is of two types: In case of superior goods ‘or’ normal goods the income demand curve [I.D.] slopes upwards from left to right. Superior goods mean ‘best quality goods’. In the case of Inferior goods the I.D. slopes downwards form left to right inferior goods means “less quality goods”. The Institute of Cost Accountants of India 23 Fundamentals of Business Economics and Management Inferior goods: Inferior goods Normal goods/ superior goods Figure: 1.8 Demand Curve – Normal Goods and Inferior Goods 3. Cross Demand: It shows the relationship between price of one commodity and demand for another commodity. It means the demand for one commodity not only depends upon its price but also prices of its substitute goods and complementary goods. Dx = f [Py] The cross demand curve is in two types: It is upwards from left to right in the case of substitute goods and its slope downwards from left to right in the case of complementary goods. Substitute goods: If one good is used in the place of other good to satisfy the same want they are called substitute goods. Example: Tea & coffee, pen & pencil etc. In the case of substitute goods, there is a direct proportional relationship between price of one commodity and demand for another commodity. So, the crossed demand curves [CD] in this case is upward from left to right. Complementary goods: If two ‘or’ more goods are used jointly to satisfy the single want they are called complementary goods. Example: Milk, sugar, tea powder etc., are complementary for tea, cement, bricks, iron etc., are complementary for construction work. In this case of complementary, there is an inverse relationship between price of one commodity and demand for another commodity. So, C.D In this case slopes downwards from left to right. Complementary Substitutes Figure: 1.9 Complementary and Substitutes Goods 24 The Institute of Cost Accountants of India  Basic Concepts Change in Demand and Change in Quantity Demanded: The change in the determinants of a demand leads to the change in demand. These changes in demand are of two types. They are: 1. Extension and contraction of demand 2. Increase and decrease of demand 1. Extension and Contraction of Demand: When all the other things remain constant, a change in the price leads to the change in demand. These changes in demand are called extension and contraction of demand. When the price is decreased the demand is extended when the price is increased the demand is contracted. To explain the extension and contraction of demand a single demand curve is enough. Figure: 1.10 Change in Quantity Demanded 2. Increase and decrease of demand With the price remaining constant, if there is a change in the other determinants that leads to a change in demand then these changes in demand are called “Increase and decrease of demand”. To explain the increase and decrease of demand, single demand curve is not enough. It means new demand curves are formed. 1. When the demand is increased, the new demand curve is formed towards right to old demand curve ‘or’ preceding demand curve. 2. In the same way, when the demand is decreased, the new demand curve is formed towards left to old demand curve ‘or’ preceding demand curve. Figure: 1.11 Change in Demand The Institute of Cost Accountants of India 25 Fundamentals of Business Economics and Management Elasticity of Demand Meaning of Elasticity of demand Elasticity means sensitiveness ‘or’ responsiveness. Elasticity of Demand means degree of response in demand. Due to different demand determining factors, the elasticity of demand explains the change in demand due to the change in the determinants of the demand. Type of Elasticity of demand There are three types of elasticity of demand. They are: 1. Price elasticity of demand. 2. Income elasticity of demand 3. Cross elasticity of demand. 1. Price Elasticity of Demand: It shows the relationship between proportionate change in the demand and proportionate change in the price. It explains how much change in the price leads to how much change in the demand. Proportionate Change in Demand Ep = Proportionate Change in Price dq q Ep = dp p dq p Ep = × dp q Definition: “Elasticity of demand in a market great or small according to the demand increases much ‘or’ little for a given fall in the price and diminishes much ‘or’ little for a given rise in the price” – Marshall “Elasticity of demand is a degree of responsiveness of demand as a result of change in price. – Mrs. John Robinson Values of price elasticity of demand: There are five values of price elasticity of demand 1. Perfectly elastic demand (Ep= ∞) 2. Perfectly Inelastic demand (Ep = 0) 3. Relatively elastic demand (EP > 1) 4. Relatively Inelastic demand (EP< 1) 5. Unitary elastic demand (EP = 1) 1. Perfectly elastic demand (EP = ∞): With the price remaining constant, if there is a change in demand it is said to be perfectly elastic demand. It means that the demand may increase ‘or’ decrease without change in the price. Here the value of EP is infinity. The demand curve in this case parallel to the OX axis 26 The Institute of Cost Accountants of India  Basic Concepts Figure: 1.12 2. Perfectly Inelastic demand (EP = 0): With the change in price, if there is no change in the demand it is said to be perfectly inelastic demand. It means that the price may increase ‘or’ decrease but the demand is constant. Here the value of EP = 0. The demand curve in this case is parallel to OY axis. It holds for goods like salt, life saving drug, etc. Figure: 1.13 3. Relatively Elastic Demand (Ex: luxury goods): (EP > 1) If the proportionate change in demand is more than proportionate change in the price, it is said to be relatively elastic demand. It means a little change in the price leads to more change in demand. Here the value of EP is greater than one the demand curve in the case slopes downward from left to right. Figure: 1.14 4. Relatively Inelastic demand (ex: necessary goods) (EP < 1) If the proportionate change in demand is less than proportionate change in the price, it is said to be relatively The Institute of Cost Accountants of India 27 Fundamentals of Business Economics and Management inelastic demand. It means more change in the price leads to less change in demand. Here the value of EP is less than one. The demand curve in this case slopes down wards from left to right. But is steeper than relatively elastic demand. Figure: 1.15 5. Unitary elastic demand: (EP = 1) If the proportionate change in the demand is equal to the proportionate change in the price. It is said to be unitary elastic demand. It means the change in the demand and change in price are same. Here the value of EP is 1. Generally comfort goods have unitary elastic demand. The demand curve also slopes downwards from left to right but it is rectangular hyperbola. Fig: 1.16 Income elasticity of demand: It shows the proportionate change in demand with respect to proportionate change in income. It means it explains how much change in the income leads to how much change in demand. Proportionate Change in Demand Ep = Proportionate Change in Income dq q Ey = dy y dq y Ey = × dy q 28 The Institute of Cost Accountants of India  Basic Concepts Values:  Perfectly elastic Income demand (EY= ∞)  Perfectly Inelastic Income demand (EY = 0)  Relatively elastic Income demand (EY > 1)  Relatively Inelastic Income demand (EY < 1)  Unitary elastic Income demand (EY = 1) 1. Perfectly elastic Income Demand With the income remaining constant, if there is a change in the demand, it is said to be perfectly elastic income demand. It means the demand may increase ‘or’ decrease without change in income. Here the value of EY is infinity. The demand curve in this case is parallel to OX- axis. 2. Perfectly Inelastic Income demand: If there is no change in the demand it is said to be perfectly inelastic income demand. It means the income may be increase ‘or’ decrease but the demand is constant Here the value of EY is zero. The demand curve in this case is parallel to OY – axis. 3. Relatively elastic Income Demand: If the proportionate change in the demand is more than proportionate change in income, it is said to be relatively elastic income demand. It means a little change in the income leads to more change in demand. Here the value of EY is greater than one. The demand curve in this case slopes upwards from left to right with relatively flatter in shape. 4. Relatively Inelastic Income Demand: If the proportionate change in the demand is less than proportionate change in income, it is said to be relatively inelastic income demand. It means a more change in the income leads to less change in demand. Here the value of EY is less than one. The demand curve in this case slopes upwards from left to right with relatively steeper in shape. 5. Unitary elastic income demand: If the proportionate change in the demand is equal to proportionate change in Income. It is said to be unitary elastic income demand. It means the change in the income and changes in the demand are same. Here the value of EY is one. The demand curve in this case also upward from left to right. Cross elasticity of demand: It shows proportionate change in the demand for one commodity and proportionate change in the price of other commodity. It explains how much change in the price of one commodity leads to how much change in the demand for another commodity. Proportionate Change in Demand for goods 'x' Ep = Proportionate Change in Price for goods 'y' dqx q Ec = x dpy py dqx py Ec = × dp y qx The Institute of Cost Accountants of India 29 Fundamentals of Business Economics and Management Methods of Measurement of elasticity of demand: There are four methods to measure the elasticity of demand. They are: 1. Percentage method 2. Total outlay method 3. Point method 4. Arc method 1. Percentage Method: In this method, to measure the elasticity of demand firstly we should find out the change in demand and change in price in percentages. Then the following formula can be used: Proportionate Change in Demand Ep = Proportionate Change in Price 2. Total outlay Method: In this method, on the basis of relationship between price and total expenditure elasticity can be decided  If the total expenditure increases with the falling of the price and decrease with the raising of the price, it is said to be relatively elastic demand (EP > 1).  With total expenditure remaining constant the increase ‘or’ decrease in price it is said to be unitary elastic (EP =1).  If the total expenditure decreases with the falling of the price and increase with the raising of the price. It is said to be relatively in elastic demand (EP< 1). Price Demand Total Outlay 9 40 360 8 50 400 7 60 420 6 70 420 5 80 400 4 90 360 3. Point Method: In this method the elasticity of demand can be measured at a particular point on the demand curve. In this method the following formula can be used: Lower Segment Ep = Upper Segment Let us assume the total length of the demand curve is - 40cm. AB is the demand curve in the diagram. How the elasticity of demand can be measured on the demand curve is explained in the following way. 30 The Institute of Cost Accountants of India  Basic Concepts Figure: 1.17 PB 20 Ep at point ‘P’ = = =1 PA 20 P B 30 Ep at point ‘P1’ = P1A = =3 1 10 P B 10 Ep at point ‘P2’ = P2A = = 0.33 2 30 P B 40 Ep at point ‘P3’ = P3A = =∞ 3 0 PB 0 Ep at point ‘P4’ = P4A = =0 4 40 4. Arc Method: If there are big changes in demand and prices it is not possible to measure the elasticity of demand by the point method. So, the Arc method is introduced. In this method, the following formula can be used: Change in demand Change in price Ep = ÷ 1st demand + 2nd demand 1st Price + 2nd Price q 2 - q1 p 2 - p1 ÷ q1 + q 2 p1 + p 2 Price Demand 2 p1 1000 q1 1 p2 2000 q2 1000 -1 ÷ 1000 + 2000 2 +1 1000 3 ÷ = -1 3000 -1 = unitary Relation between AR, MR and price elasticity of demand MR = d(TR)/dQ = d(P.Q)/dQ The Institute of Cost Accountants of India 31 Fundamentals of Business Economics and Management Therefore, MR = P + Q. dP/dQ = P [ 1 + Q/P. dP/dQ ] = P [ 1 – { - dP/dQ. Q/P } ] = P [ 1 – { - 1/(dQ/dP. P/Q) }] = P [ 1 - 1/e ] where, e = (-) [ dQ/dP. P/Q ] Now, if e = 1 or, 1/e = 1 or, ( 1- 1/e ) = 0 Then, MR = 0 If e > 1 or, 1/e < 1 or, ( 1 – 1/e ) > 0 Then, MR = P ( 1 – 1/e ) > 0 If e < 1 or, 1/e > 1 or, ( 1 – 1/e ) < 0 Then, MR = P ( 1 – 1/e ) < 0 If e = infinity or, 1/e = 0 or, ( 1 – 1/e ) = 1 Then, MR = P This analysis shows that a firm should produce that level of output corresponding to which price elasticity of demand is relatively elastic (i.e., e > 1) because the firm earns positive marginal revenue (MR > 0) only at that level of output. As the marginal cost (MC) of production is assumed to be positive, so the firm should produce output where MR > 0. Importance of Elasticity of Demand The concept of elasticity of demand is of great practical importance in the sphere of government finance as well as in trade and commerce. (i) Business Decision: If the product has more elastic demand the business man fixes less price, if the product has less elastic demand he will fix the more price. (ii) Monopolist: The monopolist fixes the higher price in one market in which the elasticity of demand is less. And lower price in more elastic demand market for the same thing (or) same good. (iii) Determination of factor price: The concept of elasticity of demand also helps in determining the price of various factors of production. Factor having inelastic demand gets higher price and factors having elastic demand gets lower price. (iv) Route for international trade: If demand for exports of a country is inelastic, that country will enjoy a favorable terms of trade while if the exports are more elastic than imports, then the country will lose in the terms of trade. (v) To the government: The concept of elasticity of demand also enable the government to decide as to what particular industries should be declared as ‘public utilities’ to be taken over and operated by the state. Determinants of Elasticity of Demand: (i) Nature of the commodity 32 The Institute of Cost Accountants of India  Basic Concepts (ii) Availability of substitutes (iii) Variety of uses (iv) Possibility of postponement of consumption (v) Durable goods (i) Nature of the commodity: In the case of necessities the demand is less elastic (or) comparatively inelastic. For example rice, salt, pulses, matchbox etc. On the other hand, the elasticity of demand for luxuries is more elastic. For example, TV, DVD players, Gold, Diamonds etc. Comfort goods have unitary elastic demand. (ii) Availability of substitutes: If a commodity has substitute goods, the elasticity for that commodity is more elastic. For example, Lux soap, pears soap, ponds and Lakme creams. (iii) Variety of uses: If the goods have several uses, the elasticity of demand for it is more elastic. For example, milk, coal, electricity etc. (iv) Possibility of Postponement of consumption: There are certain goods which can be postponed for purchase. In case of these goods, the demand is elastic. But in the case of life saving medicines the demand will be inelastic because we cannot postpone the purchase of such goods. (v) Durable goods: In case of durable goods, the elasticity of demand will be less, but in case of perishable goods the elasticity of demand will be more. Theory of Consumer behaviour Consumption: Consumption is defined as the satisfaction of human wants through the use of goods and services. Determinants of consumption: 1. Present Income 2. Future income 3. Wealth income The concept of consumer surplus: This concept was introduced by Alfred Marshall. This concept is derived from the Law of Diminishing Marginal Utility. Consumer Surplus (C.S.) is the difference between willing price and actual price. C.S. = Willing Price – Actual Price or C.S. = Demand Price – Market Price The Institute of Cost Accountants of India 33 Fundamentals of Business Economics and Management Definition: The excess of price which a consumer would be willing to pay for a thing rather than go without the thing and over what he actually does pay. Law of Diminishing Marginal Utility: The law of D.M.U explains the common experience of every consumer. It is based upon one of the characteristics of wants i.e. “A particular want is suitable”. According to this law, when a person goes on increasing the consumption of any one commodity the additional utility derived from the additional units goes on diminishing. So, it is called law of diminishing marginal utility. The law of D.M.U was firstly profounded by H.H. Gossan in 1854. So, it is called Gossans’ first law of consumption. The law of D.M.U was developed by Alfred Marshall. Definition: “The additional benefit which a person derives from a given increase in his stock of anything, diminishes with every increase in the stock that he already has”. - Marshall Concepts in this law: 1. Total utility: It is the total amount of satisfaction obtained by the consumer by the consumption of total units of a thing. The sum of marginal utilities is also called total utility. TUx = f[Qx] Or TUx = ΣMUx 2. Marginal Utility: It is the additional utility obtained by the consumer by the consumption of additional unit of a thing ‘or’ one more unit of a thing. The change in the total utility is also called marginal utility. MUx = ∆TU ∆P Or MUn = TUn - TUn - 1 Table explanation: Units Total utility Marginal utility 1 40 40 2 70 30 3 90 20 4 100 10 5 100 0 6 90 -10 34 The Institute of Cost Accountants of India  Basic Concepts Diagrammatic Explanation: Figure: 1.18 Marginal Utility & Total Utility Curve Main Points: 1. When total utility Increases, then the Marginal utility diminishes. So, T.U. Curve moves upward from left to right and M.U curve slope downwards from left to right. However, this is only true when the law of diminishing marginal utility operates. Initially, it may so happen that the marginal utility might be rising along with the total utility curve for a particular commodity. 2. When the total utility reach the maximum, then the marginal utility is zero. At this point T.U curve reached the peak stage and M.U curve intercepts ‘X’ axis. 3. When the total utility goes on diminishing then the M.U becomes negative. So, the T.U curves slopes downwards and M.U curve crossed the x-axis. Assumptions: 1. The units are homogeneous. 2. The units must be of reasonable size. 3. There is a onetime gap between one unit of consumption and the next unit of consumption. 4. There is no changes in the taste and preferences of the consumer. Exceptions to Diminishing Marginal Utility: 1. Collection of the rare goods. 2. Hobbies 3. Misers 4. Money and gold 5. Reading of books The Institute of Cost Accountants of India 35 Fundamentals of Business Economics and Management Importance: 1. Value paradox 2. Basis for economic laws 3. Progressive Taxation 4. Re-distribution of wealth Demand Forecasting: The success of the business firm depends upon the successful demand foresting. Estimation of future demand for product at present is called demand forecasting. Methods of Demand forecasting: 1. Expert opinion method 2. Survey of buyers intensions 3. Collective opinion method 4. Controlled experiments 5. Statistical method. 1.3.2 Supply Meaning of supply: There is a difference between stock of the goods and supply of goods. Supply means sum of the part of stock of the goods which is prepared by a seller to sell at a particular price, at a particular market in a particular period of time. Determinants of supply: The supply of any commodity depends upon some factors. They are called determinants of the supply. They are: 1. Price of the goods: Price of the goods is main determinant of supply. Producers supply more goods if the prices are high. They supply the fewer goods when the prices are low. 2. Goals of the firm: Firms may try to work on various goals. For e.g. Profit maximization, sales maximization, employment maximization. If the objective is to maximize profit, then higher the profit from the sale of a commodity, the higher will be the quantity supplied by the firm and vice-versa. 3. Inputs Prices: The producers supply more when the inputs prices are low, that is at lower costs of production. At higher input, price rises and the supply is reduced. 4. Technology: New Technology generally helps to save inputs and reduces costs and time to produce the output. An improved technology enhances the supply of the goods. 5. Government Policies: Government policy of taxes and subsidies on goods brings about changes in supply, higher taxes on goods discourage producers and their supply will be less. On the other hand, subsidies from government encourage producers to supply more. 36 The Institute of Cost Accountants of India  Basic Concepts 6. Expectation about future prices: If the producers expect an increase in the price of a commodity, then they will supply less at the present price and hoard the stock in order to sell it at a higher price in the near future. This will be opposite in case if they anticipate fall in future price (e.g. Fruit seller). 7. Prices of the other commodities: Usually an increase in the prices of other commodities makes the production of that commodity whose price has not risen relatively less attractive. We thus, expect that other things remaining the same, the supply of one commodities falls the price of other goods rises. 8. Number of firms in the market: Since the market supply is the sum of the suppliers made by individual firms, hence the supply varies with changes in the number of firms in the market. A decreases in the number of firm reduces the supply. 9. Natural factors: Supply of goods depends on favourable weather conditions. Conditions like drought, floods, extreme weather, pests and diseases disturb crop production and raw material supply. This will affect the supply of goods. Law of Supply: It explains the functional relationship between supply of a good and price of the good. When all other things remaining constant, if the price rises supply also increased, if the price falls supply also falls. It means there is direct or proportional relationship between price and supply. Supply function: The supply function explains the relationship between the supply and the factors that determines the supply. This can be explained through an equation: Sx = f (Px, PI, T, W, GP) In the above equation Sx = supply of goods ‘x’ f = functional relationship Px = Price of ‘x’ PI = Price of inputs (factors) T = Technology W = Weather conditions GP = Government policy Supply Schedule: It shows the various quantities of the goods that are supplied at various levels of prices. The Institute of Cost Accountants of India 37 Fundamentals of Business Economics and Management Types of supply schedule: There are two types of supply schedule. They are: 1. Individual supply schedule 2. Market Supply schedule 1. Individual supply schedule: It shows various quantities of the goods that are supplied by an individual seller (or) producer at various levels of prices in the market. Price of x Supply of ‘x’ goods 500 0 1000 10 1500 30 2000 55 2500 90 Supply curve: From the above supply schedule the supply curve can be drawn Figure: 1.19 2. Market Supply schedule: It shows the various quantities of the goods that are supplied by various producers (or) sellers at various levels of prices in the market. When we add the supply of all sellers then total supply ‘or’ market supply can be obtained. Whether the individual supply curve ‘or’ market supply curve slopes upward from left to right as there is a direct proportional relationship between price and supply. Exceptions to the law of supply: Land (or) Agriculture goods. 38 The Institute of Cost Accountants of India  Basic Concepts In the case of land (or) Agriculture goods the supply curve is parallel to OY-axis. Rare goods. In the case of rare goods supply cannot be changed according to the price. So in the case of rare goods the supply curve is parallel to OY-axis. Supply of labour. In the case of labour, the supply curve is backward bending. Because in the initial stage if the wage level is increased the supply of the labour also increased. Beyond a certain stage, if the wages are increased people will substitute leisure for paid worktime. So, the supply of labour will be decreased. Change in Supply: If the change in the determinants of the supply leads to the change in supply. These changes in supply are two types. They are: 1. Extension and contraction of the supply 2. Increase and decrease of the supply. 1. Extension and contraction of the supply: When all other things remaining constant, if there is a change in the price that leads to change in the supply then these changes in the supply are called extension and contraction of the supply. When the price is increased the supply will be extended, when the price is decreased the supply will be contracted. To explain the extension and contraction of the supply a single supply curve is enough. Fig: 1.20 2. Increase and decrease of supply: When the price is constant, if there is a change in any one of the determinants that leads to change in supply, then these changes in supply are called increase and decrease of supply. To explain the increase and decrease of the supply a single supply curve is not enough. It means new supply curves are formed.  When the supply is increased the new supply curve is formed towards right to the old supply curve.  In the same way when the supply is decreased the new supply curve is formed towards left to the old supply curve. The Institute of Cost Accountants of India 39  Fundamentals of Business Economics and Management Figure: 1.21 Elasticity of supply: It shows the ratio of the proportionate change in the supply and the proportionate change in price. It means it explains the responsiveness of supply to a change in price. dq Proportionate change in suppy q = Es = Proportionate change in price dp p dq p = × dp q Values of Elasticity of Supply: There are five values of elasticity of supply 1. Perfectly elastic Supply (Es= ∞) 2. Perfectly Inelastic Supply (Es = 0) 3. Relatively elastic Supply (Es > 1) 4. Relatively Inelastic Supply (Es< 1) 5. Unitary elastic Supply (Es = 1) 1. Perfectly elastic Supply (Es= ∞): When the price is constant if there is a change in supply, it is said to be perfectly elastic supply. It means the supply may increase ‘or’ decrease without change in price. Here, the value of Es is infinity. The supply curve in this case is parallel to OX axis. 2. Perfectly Inelastic Supply (Es = 0): When the price is changed, if there is no change in the supply, it is said to be perfectly inelastic supply. It means the price may increase ‘or’ decrease but the supply is constant. Here the value of Es = 0. The supply curve in this case is parallel to OY axis. 40 The Institute of Cost Accountants of India  Basic Concepts 3. Relatively elastic Supply (Es>1): If the proportionate change in supply is more than proportionate change in the price. It is said to be relatively elastic supply. It means a little change in the price leads to more change in supply. Here, the value of Es is greater than one the supply curve in the case upwards from left to right. 4. Relatively Inelastic Supply (Es 1], the perishable goods have less elastic [EP 1]. In the short period, the elasticity of supply will be less [ES1] (or) [ES1]. 5. Nature of inputs: If the inputs are available in the market, there is a more elastic supply otherwise less elastic supply. 6. Risk taking: If the entrepreneur takes the risks the elasticity of supply, there will be more otherwise less. 1.3.3 Equilibrium Equilibrium price means constant price (or) unchanged price. According to classical economists, the price of a good is determined by the combined actions of the buyers and sellers. It is nothing but the demand and supply. It is actually the price at which the quantity demanded of a commodity equals the quantity supplied. This can be explained by the following diagram: The Institute of Cost Accountants of India 41 Fundamentals of Business Economics and Management Figure: 1.22 According to the above diagram, both demand and supply are equal at OQ level. So equilibrium price is determined as ‘OP’. At the price of P1, the supply is more than the demand. At the Price of P2 the demand is more than supply. So, P1 and P2 are not equilibrium prices. Equilibrium price means constant price (or) unchanged price. But this equilibrium price can also be changed whenever there is a total change in the demand and total change in supply. This can be explained by the following cases. Case – I When the supply is constant, and the demand is changed, the price movements are as follows: Figure: 1.23 When supply is constant, if the demand is increased equilibrium price is also increased. When the demand is decreased the equilibrium price is also decreased. 42 The Institute of Cost Accountants of India  Basic Concepts Case-II Demand is constant and supply is changed. If the demand is constant and the supply is increased then price will be decreased and if the supply is decreased the price will be increased. Figure: 1.24 Case-III When both demand and supply change in the same proportion. When both demand and supply are increased in same proportion there must be not change in the equilibrium price. In the same way when both D/S are decreased in same proportion, price is at the equilibrium. Figure: 1.25 The Institute of Cost Accountants of India 43 Fundamentals of Business Economics and Management Case – IV: When the proportionate change in demand is more than the change in supply and less change in supply. If there is a more increase in demand and less increase in supply that leads to increase of the price. Figure: 1.26 Case – V When the proportionage change in the supply is more than the proportionate change in demand it leads to decrease of the price. Figure: 1.27 Case – VI When the demand is increased and supply is decreased, the new equilibrium price will be increased. In the same way, when the supply is increased and demand is decreased the equilibrium price will be decreased. 44 The Institute of Cost Accountants of India  Basic Concepts Theory of Production 1.4 1.4.1 Meaning of Production Generally production means a process to change the raw materials into final goods (or) finished goods. But in economics making of the goods (or) creation of goods (material and non-material) for the purpose of selling them in the market is called production. 1.4.2 Factors of Production and their Classifications Land: Land in common usage is soil or surface of the earth. As a factor of production, it refers to all natural resources like forests, water, climate, minerals etc. It mainly supplies food to people, provides space for work and supplies raw material to industry. Land has certain peculiar features: 1. Gift of nature: Land is a gift of nature. Location of land, deposits of minerals at certain places and Climatic conditions are no doubt gift of nature. 2. Limited in supply: The total geographical area of a country remains the same. In fact, certain resources like oil, gas, coal and some species of wild life may not be available after some time. 3. Immobile factor: Land cannot be moved from one place to another like other factor. However, its ownership can be transferred and its use can be shifted from one crop to another crop. 4. Diminishing returns: Early economists held the view that land is subject to the law of diminishing returns. Increased use of capital and labour on any given quantity of land would give us diminishing returns. 5. Land differs in fertility: There will be differences in fertility of land. As a result, the output changes from one plot to the other. It is because of these peculiarities of land, the early economists considered land as a separate factor of production. Labour In the ordinary usage, labour stands for only physical labour. In economics, labour means physical as well as mental services engaged in production to earn income. Classical economists and Karl Marx have considered labour as the sole factor of production. The Institute of Cost Accountants of India 45 Fundamentals of Business Economics and Management Features of Labour: Labour as a factor of production possesses certain peculiar features: 1. Labour is inseparable: Labour is inseparable from labourer but in the case of other factors i.e. land and capital are separable from land lord and capitalist. 2. Labour is perishable: If a worker does not find work on a particular day, the labour is lost for that day. Like other factors of production, labour cannot be preserved. 3. Supply of labour: Labourers offer more labour at lower wages. When wages rise beyond a certain level they prefer to enjoy leisure and supply less labour. It is observed that supply curve of labour is backward bending at higher wages. 4. Weak-bargaining power: Labour has less bargaining power as it is a perishable thing. In the same way the trade unions are not strengthened so they cannot fight for better wages. 5. Differ in efficiency of labour: Some labourers have more efficiency and some labourers have less efficiency. Capital: In the ordinary sense capital means money for an individual or a firm. Money is a form of capital when it is used to purchase machinery, tools, raw materials etc. Ultimately it is these man made goods i.e. Machinery, tools etc. that help in the production of goods. These are vital in raising productivity in different sectors. Functions of capital: Capital performs certain important functions in production such as: 1. Capital supplies tools and machines: Capital supplies tools and machines that assist the labourers in working efficiently and producing maximum output. A labourer backed by better tools and machines will be more efficient in production. 2. Improves productivity of labourer: Capital improves per capita productivity of labourer. This in turn increases the overall production. 3. Capital supplies raw materials: Capital supplies raw materials, which is required on a continuous basis for production of goods. 4. Generate more employment: Additional tools and machines generate more employment to people. However, in the modern production labour replacing machines reduce employment opportunities. 5. Provides transport facilities: Capital in the form of roadways, railways, ships help to transport raw material to the site of the production and finished goods to the market. 46 The Institute of Cost Accountants of India  Basic Concepts 6. Payments of factor: Capital in the form of money is useful for the payment of advance wages to the labourers. Even before the goods are sold in the market. Entrepreneur: The person who organizes the production is called an entrepreneur. He is considered as a separate factor because he performs specific functions different from those of other factors. Now-a-days an entrepreneur is not considered as a separate factor but as special type of human labourer. Whenever the ownership and the management are one and the same entrepreneur has to perform certain specific functions. Functions of the entrepreneur: 1. Initiation the Business: Entrepreneur has to initiate the business by mobilizing other factors. All the primary work to start the business will be undertaken by him. 2. Decision making: Major decisions like the kind of good to be produced, size of the unit, quantity of output, price, marketing etc. have to be made by him. 3. Choosing the technolog