Year: 2020

Business economics is generally applied microeconomics. It normally bridges up the business gap that exists between business practices and pure economic theory. It encompasses logical science, mathematics, decision science, and economics. These concepts usually help in taking rational and optimal business decisions. Business economics integrates theories of economics with business practice. In short, business economics is a decision making science.

I am going to provide copious details on the importance of business economics. They are not limited to the following benefits.

1. It covers demand analysis and forecasting

Demand analysis is always crucial in identifying the different factors that often influence the demand for the product of the firm. It offers clear guidelines on how to manipulate demand. Normally, the core area of business decision making relies on demand accurate estimate.

Forecasting is a critical topic that is studied in business economics. Each business enterprise initiates and progresses in its process of production based on the demand anticipation for its products in the future. It conducts a market survey and enables research with a view to understanding the fashions, tastes, and preferences of consumers. Business economics usually analyzes the behavior of the demand and predicts the quantity that is demanded by the consumers.

2. Plays a key role in cost analysis

Business economics often handles the analysis of various costs that business firms incur. Every business always desires to minimize their costs and maximize its profits by embracing different economies of scale. Nonetheless, the firms fail to determine exact costs that are involved in the production process. Business economics often deals with the cost estimates and offers knowledge to the business people concerning cost analysis of their enterprise.

3. Profit analysis

Most firms desire to gain maximum profits, however, they often experience risk and uncertainty in getting the maximum profits. The business has to come up with new innovations in marketing and production of its products. Business economics handles issues regarding profit analysis such as profit policies, techniques and even break down the analysis.

4. Capital management

Business economics covers capital management where it further denotes control and planning of expenditure of capital in a business firm. It normally covers areas such as rate of return, selection of best project, cost of capital and evaluation among other topics.

5. It covers and determines production analysis

One feature of factors of production is that are normally scarce and usually have alternative uses. In most cases, producers conjoin these factors of production in a certain way in the production process to accomplish maximum output. Business economics sheds more light concerning factor productivity, production function, least cost inputs combination among others.

6. Price determination and its techniques

Appropriate pricing decisions normally influence on how a firm can maximize its profits. Business economics deals with different techniques of price determination under various categories of market structures. Other topics related to price determination and their methods that are covered by business economics are not limited to pricing objectives, price discrimination, pricing methods, pricing of a joint product among others.

7. Has an influence on objectives of a business firm

It is important to appreciate the fact that, each and every business enterprise has an objective to achieve. A firm should ensure that its objectives should work with the way business wants to accomplish its goals. The objectives of a business entire often offer a clear guideline to the owner of the business while he/she focuses on making informed decisions concerning its output and price. The objective of the firm might revolve around sales maximization, profit maximization, satisfaction maximization, utility maximization among other objectives. Business economics normally covers theories concerning the objectives of a business organization propounded by various economics.

8. Business environment

It goes without saying that the business environment always has a significant effect on business organizations. Note that, business economics usually studies about several categories of business environment inclusive of business phase cycle, capital market and situation of money, market structure among other crucial topics. Business environment and business economics are complementary to each other.

Of late, there has been a new trend regarding integration of operation research and business economics, where methods like inventory models, linear programming, the theory of games are regarded as part of important areas to study in business economics. Therefore, business economics is a very important element that allows most organizations and individuals to accomplish their goals.

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

• Opportunity cost
• Incremental principle
• Principle of the time perspective
• Discounting principle
• Equi-marginal principle

1. Opportunity cost principle

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision.

For e.g.

• The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures.
• The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products.
• The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs.

2. Incremental principle

It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

• Incremental cost
• Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if:

• It increases revenue more than costs
• It decreases some costs to a greater extent than it increases others
• It increases some revenues more than it decreases others and
• It reduces cost more than revenues”

3. Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations.

For example

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis

From the above example the following long run repercussion of the order is to be taken into account:

• If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution.
• If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.

In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”.

4. Discounting Principle

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasons:

• The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of
• Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108

5. Equi marginal Principle

This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.

Tables are the simplest and most direct form for presenting economic data. When these data are displayed electronically in the format of an accounting income statement or balance sheet, the tables are referred to as spreadsheets. When the underlying relation between economic data is simple, tables and spreadsheets may be sufficient for analytical purposes. In such instances, a simple graph or visual representation of the data can provide valuable insight.

Complex economic relations require more sophisticated methods of expression. An equation is an expression of the functional relationship or connection among economic variables. When the underlying relation among economic variables is uncomplicated, equations offer a compact means for data description; when underlying relations are complex, equations are helpful because they permit the powerful tools of mathematical and statistical analysis to be used.

Functional Relations: Equations

The easiest way to examine basic economic concepts is to consider the functional relations incorporated in the basic valuation model. Consider the relation between output, Q, and total revenue, TR. Using functional notation, total revenue is

TR = f(Q)

Equation is read, “Total revenue is a function of output.” The value of the dependent variable (total revenue) is determined by the independent variable (output). The variable to the left of the equal sign is called the dependent variable. Its value depends on the size of the variable or variables to the right of the equal sign. Variables on the right-hand side of the equal sign are called independent variables. Their values are determined independently of the functional relation expressed by the equation.

Equation does not indicate the specific relation between output and total revenue; it merely states that some relation exists. Equation provides a more precise expression of this functional relation:

TR = P×Q

where P represents the price at which each unit of Q is sold. Total revenue is equal to price times the quantity sold. If price is constant at $1.50 regardless of the quantity sold, the relation between quantity sold and total revenue is

TR = f(Q)

Data in Table are specified by Equation and graphically illustrated in Figure.

Total, Average, and Marginal Relations

Total, average, and marginal relations are very useful in optimization analysis. Whereas the definitions of totals and averages are well known, the meaning of marginals needs further explanation. A marginal relation is the change in the dependent variable caused by a one-unit change in an independent variable. For example, marginal revenue is the change in total revenue associated with a one-unit change in output; marginal cost is the change in total cost following a one-unit change in output; and marginal profit is the change in total profit due to a one-unit change in output.

Relation Between Total Revenue and Output; Total Revenue = $1.50

Marginal cost

The marginal cost is the increase in total cost as a consequence of an increase in a production unit, or in mathematical terms, it is the first differential quotient of the total cost function. This can be expressed as a partial derivative of change of total costs and variation in one unit of production.

It is useful using marginal cost to check the convenience of velocity of production of a firm into multiple levels of production:

The law of increasing returns implies that production is increasing more with impact of one additional unit of production, therefore the marginal cost gradient, as the second derivate of marginal cost is below 0 and firm is reducing marginal costs as result of production.

The second scenario is law of constant returns, where the total cost curve is regular and smooth and change in productions maintain the same marginal cost and marginal cost gradient is equal to 0.

The law of diminishing returns applies where total cost curve is convex and marginal cost increases monotonically, being marginal cost gradient positive when production increase.

Firm´s decision to maximize profit depend greatly if marginal cost are lower than price of product, expanding production until marginal cost is equal to price.

Average cost

Average costs represent the quotient of the ordinate and abscissa of a point on the total cost curve. Also it is named as cost of velocity of production, where it measures the cost per unit, taking in consideration fixed cost and variable costs, divided on total production.

The average cost can be explained in two components:

• Variable cost: where it is included only costs related to velocity of production.
• Fixed cost: related with investment required to produce the firm but it does not depend on velocity of production.

The average cost start declining as result of average fixed cost falls with velocity of production. However, it will rise, as impact of fixed factors constrains production, limiting the benefits of increase production and impact in total cost per unit. To move from a lower average cost, firm requires increase the fixed factors of production to move to a new lower point, developing scale economics. As result of behavior of fixed and variable cost, average cost shape is U form.

The usage of average cost is useful to know about total costs incurred by firm based on units of productions. Every velocity of production has a cost covering price and depending the amount of production with lowest cost covering prices is where enterprise can sell without generating losses. However, if firm is looking return investment, the respective price must be equal to average cost to recover fixed cost and variable costs.

Average Cost vs. Marginal Cost Comparison Table

 Average Cost vs. Marginal Cost

1. Average cost is nothing but the Total cost divided by the number of units manufactured which shows the result as per unit cost of the product, whereas Marginal cost is extra cost generated while producing one or some extra unit of products and it is calculated by dividing the change in total cost with Chang in total manufactured unit.
2. Marginal cost considered all cost which fluctuates during the level of production and fixed cost remain constant up to a certain level of production, whereas Average cost considered Fixed cost and Variable cost. In Average cost, both Fixed and Variable cost is product cost whereas in margin cost Fixed cost is considered as period costs and Variable cost is product cost.
3. Average cost calculates the effect on total unit due to change in output level whereas marginal cost is calculated to find out if producing one extra unit of product is profitable or not.
4. Average cost method also called a weighted average method and Marginal cost method is also called as variable costing.
5. Both average cost vs marginal cost is measured under the same units and obtain the result from Total cost.
6. If an objective is to increase profit during production level than the marginal cost technique is useful and when an objective is to reduce cost during production level, in that case, the Average cost technique is used.

Marginal cost vs. Average cost both are costing technique used to calculate the cost of the product which incurred while manufacturing. It helps an organization to set the final price of the product and cover all its expenses through it. Marginal cost method helps an organization to increase profitability at the production level and the Average cost method helps an organization to reduce cost at the production level. Average cost helps to understand how much expenses incurred while producing a single of product and Marginal cost helps to understand how much extra cost will incur while producing one extra unit of product.

Marginal cost does not depend on fixed cost because it does not change with output, or it remains constant up to a certain level of production whereas variable cost change with the output, so in short marginal cost is due to change in variable cost. The average cost considers both fixed cost and variable cost of the product which is called Total cost. The average cost and Marginal cost effect each other as the production varies. When average cost decreases in that case marginal cost is less than the average cost and vice versa and when the average cost is the same or constant in that case both are equals to each other. Marginal cost plays an important role in economics as it shows the costs at a very definite point in time. Even though the average and marginal cost is an important concept for an organization but some time pricing of products with this method leads to a significantly different result.

Marginal analysis plays a crucial role in managerial economics, the study and application of economic concepts, to guide in making managerial decisions. The idea is to predict and measure the impact of per unit changes of an organization’s goals, ultimately identifying the optimal resource allocation given the constraints of the business.

The Value of Marginal Analysis for Management

Most of the microeconomic theory of marginalism was developed by Cambridge University professor and economist Alfred Marshall. He stated that production is only beneficial for a firm when marginal revenue exceeds marginal cost, and it is most beneficial when the difference is largest.

For instance, a toy manufacturer should only produce toys until marginal expense is equal to marginal benefit. By breaking down decisions into measurable, smaller pieces, the toy manager can optimize profits.

Marginal analysis has applicability well outside the range of for-profit production processes. Every resource allocation decision can benefit from marginal analysis as long as costs and benefits are identifiable.

Attaining the Highest Net Benefit

Suppose a company is able to measure the additional benefits and costs of extra economic activity. The theory of marginal analysis states that whenever marginal benefit exceeds marginal cost, a manager should increase activity to reach the highest net benefit. Similarly, if marginal cost is higher than marginal benefit, activity should be decreased.

Sunk costs, fixed costs, and average costs do not affect marginal analysis. They are irrelevant to future optimal decision-making. Marginal analysis can only address what happens if the firm hires one additional employee, produces one additional product, devotes additional space to research and so forth.

Marginal Analysis and Opportunity Cost

Managers should also understand the concept of opportunity cost. Suppose a manager knows that there is room in the budget to hire an additional worker. Marginal analysis tells the manager that an additional factory worker provides net marginal benefit. This does not necessarily make the hire the right decision.

Suppose the manager also knows that hiring an additional salesperson yields an even larger net marginal benefit. In this case, hiring a factory worker is the wrong decision because it is sub-optimal.

Market demand is similar to industry demand. It is a broader concept and it involves total demand of a product in an industry. For example, demand of two wheelers in India implies demand of two wheelers produced and marketed by all the companies. It reveals the broader picture of demand. Marketer should keep in mind the wider scenario of industry/market demand to see his position, often called market share of company in an industry. Market demand plays a vital role in formulating the broad marketing programme.

Philip Kotler: “Market demand for the product is the total volume that would be bought by a defined customer group in a defined geographical area in a defined time period in a defined marketing environment under a defined marketing programme.”

Thus, market demand indicates total sales of the product to the specific groups of buyers in a specific period and in defined geographical areas in a given marketing environment.

Elements of Market Demand

Systematic analysis of above stated definitions necessarily reveals following elements:

1. Product

Market demand indicates the total demand of specific products in an industry. The place or scope of product must be specified. In which category or industry the product of company falls. It can be decided on the basis of who are the users and the purpose of using the product. Thus, we must mention the market demand in relation to the specific product.

2. Total Volume

It shows the total volume of sales in form of unit or value. It suggests the total sales of the product in the industry. For example, total volume means the amount (or units) of total demand of refrigerator in India.

3. Purchase or Buying

Only the quantity, that is ordered and purchased is included in market demand. Market demand includes units, which are ordered, delivered, or consumed.

4. Customer Groups

Market demand is expressed in term of different users. Total volume demanded by different groups of customers, such as industrial customers, institutional customers, and individual customers.

5. Geographic Area

Market demand can be specified in term of different geographical areas or localities. It may be in term of country, state, region, district, or any geographic unit.

6. Fixed Time Duration

Market demand is meaningful only if it is expressed in relation to time. For example, demand of two-wheeler during the year 2007. Time may be in term of week, months, quarter, or year.

7. Marketing Environment

Obviously, market demand is influenced by several factors. These factors constitute the marketing environment. So, it is necessary to mention assumptions about marketing environment comprising economic, cultural, social, political, etc., forces.

8. Definition of Marketing Programme

Market demand is affected by marketing programme/strategy. So, it is clarified with reference to a specific marketing programme including product, price, promotion, and distribution. Thus, market demand is stated in context with the definite marketing programme.

While estimating market demand, these all elements should be considered for meaningful picture of total demand. Here, we must distinguish market demand from company demand. Market demand is total demand of the product in an industry, and company demand means demand of the individual business unit’s products. Market forecast relates with market demand and sales forecast relates with company demand. However, market demand forecast and sales forecast are taken loosely (i.e., more or less similar).

Firm Demand (company demand) denotes the demand for the product/s of a particular firm. While Industry demand means the demand for the product of a particular industry. An industry comprises all the firms or companies producing similar products which are quite close substitutes to each other irrespective of the differences in their brand names. To understand the relation between company and industry demand necessitates an understanding of different market structures.

1. Demand Curve under Perfect competition

Under Perfect Competition industry demand is completely different from the individual firm demand. The industry demand curve is downward sloping. The price in the market is determined by the interactions of the forces of demand and supply. The point of intersection between demand and supply curves determines the equilibrium price of the product. Now the number of firms under Perfect Competition is so large that a single firm has no influence on either the total output or the price. Its contribution to total output is just microscopic. If a new firm enters or an existing firm takes an exit the total output does not get affected much. A firm under Perfect Competition cannot fix the price of its product. It will have to sell its product at the going market price as it is determined by demand and supply forces in the market. A firm under Perfect Competition is a price taker and not a price maker. Price is given to the firms and each unit of its output is sold at the given market price and thus the demand curve of firm or its average revenue curve becomes horizontal. Horizontality of average revenue curve (demand curve) is the acid test of a firm under Perfect Competition.

Nature of Demand Curve under Perfect competition

In case of perfect competition, there are very large no. of buyers and sellers selling a homogeneous product at a price fixed by the market. Therefore, each firm is a price taker and faces a perfectly elastic demand curve.

2. Demand Curve under Monopolistic competition

Under Monopolistic Competition there is competition among a group of monopolists producing differentiated product. The product of each firm is slightly different from that of other. There are also substitutes and therefore the demand curve of each firm’s product is downward sloping and is relatively elastic in nature. In monopolistic competition there are many sellers with differentiated product and hence industry demand curve hardly has any meaning.

Nature of Demand Curve under Monopolistic competition

Under monopolistic competition, large no. of firms selling closely related but differentiated products makes the demand curve downward sloping. It implies that a firm can sell more output only by reducing the price of its product.

3. Demand Curve under Monopoly competition

The demand curve of an individual firm is not the same as the industry or market demand curve except in case of monopoly. Monopoly is that market category in which there is only a single seller and therefore there is no difference between a firm and an industry. The firm is itself an industry and therefore the demand curve of the individual firm as well as the industry demand curve under monopoly will be the same and as we shall see later is downward sloping. Moreover as there are no close substitutes under monopoly the demand curve is relatively steeper showing relatively inelastic demand under monopoly.

Nature of Demand Curve under Monopoly competition

A monopoly firm is like an industry as the single seller constitutes the entire market for the product, which has no close substitutes. So, a monopolist has full freedom and power to fix price for the product. However, demand of the product is not in the control of monopoly firm. In order to increase the output to be sold, the monopolist will have to reduce the price. Therefore, monopoly firm faces a downward sloping demand curve.

4. Demand Curve under oligopoly competition

In case of Oligopoly market there are few sellers producing either differentiated or homogenous products. The demand for a firm’s product is influenced by the actions of its rivals. The demand curve of a firm under oligopoly has a kink.

Nature of Demand Curve under oligopoly competition

The demand curve for an oligopoly firm is indeterminate, i.e. it cannot be drawn accurately as exact behavior pattern of a producer cannot be ascertained with certainty.