Basics of
Business Economics
Definition
Business Economics* is
‘The application of economic theories and
methodologies to problems faced by
the business firms / industry’.
*Business Economics is also termed as Micro Economics, Managerial Economics
or Applied Economics.
The Business Environment
• Business Economics is about
– decision making in business
• external influences on the firm
– the business environment
• internal decisions of the firm
• the external effects of business decision making
• What do business economists do?
– description
– analysis
– recommendations
Scope of Business Economics
• Resource allocation
– Production programming, transportation problems,
assignment problems
• Inventory and queuing problems
– Optimal level of stocks of raw materials and finished
goods
– Installing additional machines and hire extra labour
• Pricing problems
– How, what, when, strategies…
• Investment problems
– Investing in plants, raw materials, sources of funds,…
Business Economics and other disciplines
• Micro economic theory
• Macro economic theory
• Operations Research
• Theory of Decision Making
• Statistics
• Management theory and accounting
• Econometrics
Some economic concepts used by firms
• Demand and its elasticity
• Demand forecasting
• Cost analysis
• Revenue concepts
• Price determination under different
market structures
• Pricing methods in actual practice
• Break-even analysis
• Capital budgeting and management
• Criteria for public investment decisions
Basic Concepts
Basic Concepts
• Objectives of firm
• Theory of Demand and elasticity of
demand
• Theory of Supply
• Opportunity Cost
• Marginalism
• Production Possibility Curves
• Different types of Costs
• Time perspective of money and
discounting
Basic Concepts
• Risk and uncertainty
• Profits
• Firm, industry and market
• GDP, GNP, NNP
• National income
• Aggregate demand and aggregate supply
• Per capita income
• Economic and econometric models
Objectives of Firm
Firm’s Objectives
• Growth
• Profit Maximization
• Firm’s value maximisation
• Sales (revenue) maximisation subject to
some pre-determined profit
• Size maximisation
• Long-run survival
Theory of Demand
Demand Schedule for Ice Cream
Price Quantity
0.10 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
Demand Curve
Price (Rs) Quantity
0.10 12
3.00 0.50 10
1.00 8
2.50 1.50 6
Price of Ice-Cream Cone
2.00 4
2.00 2.50 2
3.00 0
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
Law of demand
As the price increases, demand decreases
and vice versa
Concept of Elasticity
• … is a measure of how much buyers and sellers
respond to changes in market conditions
• It is the degree of responsiveness of
demand/supply to the change in the price/other
variables
• … allows us to analyze supply and demand with
greater precision.
• Law of demand reveals the relationship
between price and demand, whereas Elasticity
reveals the ‘degree of change’
Price Elasticity of Demand
Price elasticity of demand is the
percentage change in quantity
demanded given a percent change in
the price.
It is a measure of how much the
quantity demanded of a good responds
to a change in the price of that good.
Unit Elastic Demand
Elasticity = 1
Price
1. A 22% 5
increase
in price... 4
Demand
80 100 Quantity
2. ...leads to a 22% decrease in quantity.
Inelastic Demand
Elasticity < 1
Price
In Rs
1. A 22% 5
increase
in price... 4
Demand
90 100 Quantity
2. ...leads to a 11% decrease in quantity.
Elastic Demand
Elasticity > 1
Price
1. A 22% 5
increase
in price... 4
Demand
50 100 Quantity
2. ...leads to a 67% decrease in quantity.
Perfectly Inelastic Demand
Elasticity = 0
Price Demand
in Rs
1. An 5
increase
in price... 4
100 Quantity
2. ...leaves the quantity demanded unchanged.
Perfectly Elastic Demand
Elasticity = infinity
Price
1. At any price
above Rs. 4, quantity
demanded is zero.
4 Demand
2. At exactly Rs. 4,
consumers will
buy any quantity.
3. At a price below Rs. 4, Quantity
quantity demanded is infinite.
Supply
Supply
Quantity supplied is the amount of a
good that sellers are willing and
able to sell.
Supply Schedule
The supply schedule is a table that
shows the relationship between the
price of the good and the quantity
supplied.
Supply Schedule
Price Quantity
0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
Supply Curve
The supply curve is the upward-
sloping line relating price to
quantity supplied.
Supply Curve
Price of
Ice-Cream
Cone
3.00 Price Quantity
0.00 0
2.50
0.50 0
2.00 1.00 1
1.50 2
1.50 2.00 3
2.50 4
1.00
3.00 5
0.50
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
Law of Supply
The law of supply states that there
is a direct (positive) relationship
between price and quantity
supplied.
Elasticity of Supply
Unit Elastic Supply
Elasticity = 1
Price
In Rs Supply
1. A 22% 5
increase
in price... 4
100 125 Quantity
2. ...leads to a 22% increase in quantity.
Inelastic Supply
Elasticity < 1
Price
in Rs Supply
1. A 22% 5
increase
in price... 4
100 110 Quantity
2. ...leads to a 10% increase in quantity.
Elastic Supply
Elasticity > 1
Price
In Rs
Supply
1. A 22% 5
increase
in price...
4
100 200 Quantity
2. ...leads to a 67% increase in quantity.
Perfectly Inelastic Supply
Elasticity = 0
Price Supply
in Rs
1. An 5
increase
in price... 4
100 Quantity
2. ...leaves the quantity supplied unchanged.
Perfectly Elastic Supply
Elasticity = infinity
Price
in Rs
1. At any price
above 4, quantity
supplied is infinite.
4 Supply
2. At exactly 4,
producers will
supply any quantity.
3. At a price below 4, Quantity
quantity supplied is zero.
Production Possibility Frontier
The Production Possibilities Frontier
The production possibilities frontier is a graph
showing the various combinations of output
that the economy can possibly produce given
the available factors of production and
technology.
The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000 D
2,200
C
2,000 A
B
1,000
0 300 600 700 1,000 Quantity of
Cars Produced
The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000 D
2,200
C
2,000 A
Production
possibilities
frontier
B
1,000
0 300 600 700 1,000 Quantity of
Cars Produced
Costs
Costs
Cost is
‘the expense incurred in producing a
commodity’
Different types of Costs
• Real cost and Money cost
• Actual cost and Opportunity cost
• Past and Future cost
• Short run and Long run costs
• Variable and Fixed Costs
• Incremental costs and Sunk costs
• Direct and Indirect costs
• Replacement and Historical costs
Time Perspective
Time Perspective
• Market Period (Very Short run)
– Supply of out put is fixed, hence response to demand is
nil
• Short run
– Some increase in output is possible by better utilisation
of factors of production
– However, plant and machinery can not be changed
• Long run
– All factors are variable and there are no fixed inputs
Examples for Time Perspective
Market Period
1. Raise in price 2. Profit
to increase profit increases
4. Sharp decline
3. Sales decreases
in the profits
Long run Short run
Examples for Time Perspective
2. Cut down the
1. Reduce costs money for labour
welfare
Market Period
3. Cost reduces,
5. Reduce in
Profitability
Profitability
increases
Long run 4. Adverse effect
On labour
productivity
Short run
Discounting
Discounting
This concept is based on the simple notion
that –
“A rupee today, is worth more than a
rupee tomorrow”
Underlying principle in discounting
i. Uncertainty
ii. Capability of money to earn Interest
Example…
If the rate of interest is 8%, Present value of
my Rs. 100 is
PV = Rs.100 / 1 + 8 % = Rs. 92.59
Risk and Uncertainty
• Foreseeable risks
– Fire, theft, death, sinking of ship,…
• Unforeseeable risks
– Competitive uncertainties
– Technological uncertainties
– Cyclical uncertainties
– Uncertainties caused by government policies
Profit
Profit
• Total Revenue – Total Cost = Profit
• Accounting Profit
– Total Revenue – explicit or actual costs (rents,
labour, wage, interest,…)
• Economic Profit
– Total Revenue – (explicit + implicit costs)
Firm, Industry and Market
Firm, Industry and Market
• Firm is a unit of production that employs
factors of production (or inputs) to produce
goods and services under given state of
technology
• Point to ponder
– Do firms always try to ‘Maximise Profits’?
Firm, Industry and Market
• Industry – it includes firms which are in some form
related to each other closely. This ‘closeness’ is
generally defined in terms of two criteria
• Product Criterion
– Group of firms whose products are close substitutes
• Process Criterion
– Group of firms which follows similar processes
(technology, use of raw materials, methods of
production, channels of production,…)
Firm, Industry and Market
• Market – Location or a region in which
buyers and sellers of a particular commodity
are in regular communication (market for white
goods in India, market for luxury cars in India,…)
GDP, GNP, NNP, National Income
Gross Domestic Product (GDP)
• Gross Domestic Product is = total value of
goods and services produced in a country
during the year – income from investment
abroad
GDP @ Factor 2001-02 2002-03 2003-04
Cost
(in ‘000 Crs )
At Current Prices 2081.5 2254.9 2591.8
At 93-94 Prices 1267.9 1318.4 1430.5
Source – Indian Economic Survey 2004-05
Gross National Product (GNP)
Gross National Product = GDP + income from
abroad – income earned by foreigners in the
domestic market.
GNP 2001-02 2002-03 2003-04
(in ‘000 Crs )
At Current Prices 2065.9 2241.7 2505.7
At 93-94 Prices 1257.6 1310.5 1422.5
Source – Indian Economic Survey 2004-05
National Income
National income is the aggregate factor of
income (i.e., earning from labour and capital
etc) which arises from the current
production of goods and services by the
nation’s economy.
Net National Product (NNP)
NNP is the market value of a country’s output
of goods and services, after deducting the
capital that has been used up in the
production process
Among the deductions to be made are;
depreciation charges, accidental damages
to fixed capital assets and outlays charges
to current account
NNP = GNP - Depreciation
Aggregate Demand, Aggregate Supply
and Per Capita Income
Aggregate Demand
Aggregate demand* is the total demand for goods
and services in the economy
It can be segmented into demands of
- Households for consumer goods and services
- Firms and Govt for investment goods
- Central and state Govt’s for goods and services
- Exports
* Aggregate demand determines the level of production and employment
Aggregate Supply
Aggregate Supply of goods and services in
the economy available to meet aggregate
demand.
It consists of domestically produced goods
and services + Imports
Aggregate Supply of Electric Power
Production of Electric Power in India
Year Mega Watts
91-92 69, 065
95-96 83,293
99-00 98,185
03-04 112,682
Source: Ministry of Power, GOI
Per Capita Income (PCI)
If the national income of a country is divided
by the total population, we get the average
income per head, which is known as per
capita income
National Income
PCI =
Total Population
