Unit 1: Introduction

1. Introduction to Business and Economics

1.1 Defining Economics

Economics is the social science that studies how individuals, governments, firms, and nations make choices on allocating scarce resources to satisfy unlimited wants. It focuses on the production, distribution, and consumption of goods and services.

• Scarcity: The fundamental economic problem where resources (land, labor, capital, enterprise) are limited, but human wants are unlimited.
• Microeconomics: The study of individual units (consumers, firms) and how they make decisions.
• Macroeconomics: The study of the economy as a whole (inflation, GDP, unemployment).

1.2 Business Economics (Managerial Economics)

Business Economics is the integration of economic theory with business practice. It applies economic tools and techniques to business decision-making to achieve organizational goals (usually profit maximization).

• Nature: It is pragmatic and applied. It bridges the gap between abstract theory and managerial reality.
• Scope: It covers demand analysis, cost analysis, pricing policies, and profit management.
• Normative vs. Positive:
  • Positive Economics: Describes "what is" based on facts.
  • Normative Economics: Describes "what ought to be" (involves value judgments). Business economics is largely normative (prescriptive) as it suggests optimal solutions.

2. The Law of Demand

2.1 Statement of the Law

The Law of Demand states that there is an inverse relationship between the price of a commodity and the quantity demanded, provided all other factors remain constant (ceteris paribus).

• If Price () , Quantity Demanded ()
• If Price () , Quantity Demanded ()

2.2 The Demand Curve

The demand curve is the graphical representation of the demand schedule. It is downward sloping from left to right.

Why does the Demand Curve slope downward?

1. Law of Diminishing Marginal Utility: As a consumer consumes more units of a good, the additional satisfaction (utility) derived from each new unit declines. Therefore, they will only buy more if the price drops.
2. Income Effect: When the price falls, the consumer's real income (purchasing power) increases, allowing them to buy more.
3. Substitution Effect: When the price of Good A falls, it becomes relatively cheaper than Good B. Consumers switch from B to A.

2.3 Determinants of Demand

These are the non-price factors that influence how much of a product is demanded at any given price.

1. Income of the Consumer:
   • Normal Goods: Demand increases as income increases (e.g., branded clothes).
   • Inferior Goods: Demand decreases as income increases (e.g., generic brands, public transit).
2. Price of Related Goods:
   • Substitute Goods: Goods used in place of one another (e.g., Tea and Coffee). If the price of Tea rises, demand for Coffee rises.
   • Complementary Goods: Goods used together (e.g., Cars and Petrol). If the price of Petrol rises, demand for Cars falls.
3. Tastes and Preferences: Favorable changes in fashion or trends increase demand; unfavorable changes decrease it.
4. Expectations of Future Prices: If consumers expect prices to rise in the future, they will buy more now (increasing current demand).
5. Demographics/Population: A larger population generally leads to higher demand.

3. The Law of Supply

3.1 Statement of the Law

The Law of Supply states that there is a direct (positive) relationship between the price of a commodity and the quantity supplied, assuming other factors remain constant.

• If Price () , Quantity Supplied ()
• If Price () , Quantity Supplied ()

3.2 The Supply Curve

The supply curve is the graphical representation of the supply schedule. It is upward sloping from left to right.

Rationale: Producers are motivated by profit. Higher prices imply higher potential profit margins, encouraging firms to produce more.

3.3 Determinants of Supply

Factors other than price that shift the supply curve:

1. Cost of Production (Input Prices): An increase in the cost of raw materials, labor, or energy decreases supply (shifts left). A decrease in costs increases supply.
2. Technology: Improvements in technology increase efficiency and reduce costs, leading to an increase in supply (shifts right).
3. Government Policy (Taxes and Subsidies):
   • Taxes: Viewed as a cost. Higher taxes decrease supply.
   • Subsidies: Financial aid reduces costs. Subsidies increase supply.
4. Number of Sellers: More firms entering the market increases the aggregate supply.
5. Expectations: If sellers expect prices to rise in the future, they may withhold stock now (decreasing current supply) to sell later at a higher price.

4. Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied (). At this point, there is no tendency for the price to change.

• Equilibrium Price (): The price at which the market clears.
• Equilibrium Quantity (): The amount traded at the equilibrium price.

4.1 Disequilibrium

1. Surplus (Excess Supply): Occurs when the market price is above equilibrium. . Sellers will lower prices to clear stock, moving the market back toward equilibrium.
2. Shortage (Excess Demand): Occurs when the market price is below equilibrium. . Buyers will bid up prices, moving the market back toward equilibrium.

5. Movements vs. Shifts of the Curve

It is critical to distinguish between a change in quantity demanded/supplied versus a change in demand/supply.

5.1 Movements Along the Curve

A movement occurs only when there is a change in the Price of the good itself.

• Expansion: Downward movement along the demand curve (due to price fall) or upward movement along the supply curve (due to price rise).
• Contraction: Upward movement along the demand curve (due to price rise) or downward movement along the supply curve (due to price fall).
• Terminology: Referred to as "Change in Quantity Demanded" or "Change in Quantity Supplied."

5.2 Shifts of the Curve

A shift occurs due to changes in Determinants (Non-Price Factors) (e.g., Income, Tech, Tastes). The entire curve moves.

• Rightward Shift: Increase in Demand or Supply.
• Leftward Shift: Decrease in Demand or Supply.
• Terminology: Referred to as "Change in Demand" or "Change in Supply."

6. Elasticity of Demand

6.1 Concept of Elasticity

Elasticity measures the responsiveness or sensitivity of one variable to a change in another variable. In economics, it usually quantifies how much the quantity demanded or supplied changes in response to a change in price or income.

6.2 Price Elasticity of Demand (PED)

Defined as the percentage change in quantity demanded divided by the percentage change in price.

Formula:

Degrees of Price Elasticity:

1. Perfectly Elastic (): A tiny change in price leads to an infinite change in demand. Curve is a horizontal line.
2. Relatively Elastic (): . Luxury goods usually fall here. Price cuts increase total revenue.
3. Unitary Elastic (): . Total revenue remains constant when price changes. Curve is a rectangular hyperbola.
4. Relatively Inelastic (): . Necessities usually fall here. Price increases raise total revenue.
5. Perfectly Inelastic (): Demand does not change regardless of price changes (e.g., life-saving drugs). Curve is a vertical line.

6.3 Other Types of Elasticity

• Income Elasticity: Responsiveness of demand to changes in consumer income. (Positive for normal goods, negative for inferior goods).
• Cross Elasticity: Responsiveness of demand for Good A to a change in the price of Good B. (Positive for substitutes, negative for complements).

7. Factors Affecting Price Elasticity of Demand

The following factors determine whether a good is elastic or inelastic:

7.1 Nature of the Commodity

• Necessities (Salt, Medicine): Inelastic. Consumers must buy them regardless of price.
• Luxuries (Vacations, Jewelry): Elastic. Consumers can easily forego these if the price rises.

7.2 Availability of Substitutes

• Close Substitutes Available: Elastic. If the price of Pepsi rises, consumers easily switch to Coke.
• No Close Substitutes: Inelastic. If electricity prices rise, consumers have few alternatives.

7.3 Proportion of Income Spent

• Small Proportion (Matches, Needles): Inelastic. A 10% price rise is negligible to the budget.
• Large Proportion (Cars, Housing): Elastic. Price changes significantly impact the consumer's budget.

7.4 Time Horizon

• Short Run: Inelastic. Consumers need time to adjust habits or find alternatives.
• Long Run: Elastic. Over time, consumers find substitutes or change behaviors (e.g., switching to electric cars if gas prices stay high).

7.5 Number of Uses

• Single Use: Inelastic.
• Multiple Uses (e.g., Milk, Electricity): Elastic. If the price of milk rises, consumers may stop using it for making sweets but still buy it for tea, reducing demand significantly but not entirely.

7.6 Addiction / Habit

• Habit-forming goods (Cigarettes, Alcohol): Inelastic. Consumers are less sensitive to price changes due to dependency.