CA Foundation Business Economics Study Material – Law of Demand

CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Law of Demand

The Law of Demand

  • The Law of Demand expresses the nature of functional relationship between the price of a commodity and its quantity demanded.
  • It simply states that demand varies inversely to the changes in price i.e. demand for a commodity expands when price falls and contracts when price rises.
  • “Law of Demand states that people will buy more at lower prices and buy less at higher prices, other things remaining the same.” (Prof. Samuelson)
  • It is assumed that other determinants of demand are constant and ONLY PRICE IS THE VARIABLE AND INFLUENCING FACTOR.
  • Thus, the law of demand is based on the following main assumptions:—
    1. Consumers income remain unchanged.
    2. Tastes and preferences of consumers remain unchanged.
    3. Price of substitute goods and complement goods remain unchanged.
    4. There are no expectations of future changes in the price of the commodity.
    5. There is no change in the fashion of the commodity etc.
  • The law can be explained with the help of a demand schedule and a corresponding demand curve.
  • Demand schedule is a table or a chart which shows the different quantities of commodity demanded at different prices in a given period of time.
  • Demand schedule can be Individual Demand Schedule or Market Demand Schedule.

Individual Demand Schedule is a table showing different quantities of commodity that ONE PARTICULAR CONSUMER is willing to buy at different level of prices, during a given period of time.

ca-foundation-business-economics-study-material-law-of-demand

Market Demand Schedule is a table showing different quantities of a commodity that ALL THE CONSUMERS are willing to buy at different prices, during a given period of time.

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(Assumption: There are only 2 buyers in the market)

Both individual and market schedules denotes an INVERSE functional relationship between price and quantity demanded. In other words, when price rises demand tends to fall and vice versa.

A demand curve is a graphical representation of a demand schedule or demand function.

  • A demand curve for any commodity can be drawn by plotting each combination of price and demand on a graph.
  • Price (independent variable) is taken on the Y-axis and quantity demanded (dependent variable) on the X-axis.

ca-foundation-business-economics-study-material-law-of-demand-2

  • Individual Demand Curve as well as Market Demand Curve slope downward from left to right indicating an inverse relationship between own price of the commodity and its quantity demanded.
  • Market Demand Curve is flatter than individual Demand Curve.

Reasons for the law of demand and downward slope of a demand curve are as follows:—

1. The Law of Diminishing Marginal Utility:

  • According to this law, other things being equal as we consume a commodity, the marginal utility derived from its successive units go on falling.
  • Hence, the consumer purchases more units only at a lower price.
  • A consumer goes on purchasing a commodity till the marginal utility of the commodity is greater than its market price and stops when MU = Price ie. when consumer is at equilibrium.
  • When the price of the commodity falls, MU of the commodity becomes greater than price and so consumer start purchasing more till again MU = Price.
  • It therefore, follows that the diminishing marginal utility implies downward sloping demand curve and the law of demand operates.

2. Change in the number of consumers:

  • Many consumers who were unable to buy a commodity at higher price also start buying when the price of the commodity falls.
  • Old customers starts buying more when price falls.

3. Various uses of a commodity:

  • Commodity may have many uses. The number of uses to which the commodity can be put will increase at a lower price and vice versa.

4. Income effect:

  • When price of a commodity falls, the purchasing power (ie. the real income) of the consumer increases.
  • Thus he can purchase the same quantity with lesser money or he can get more quantity for the same money.
  • This is called income effect of the change in price of the commodity.

5. Substitution effect:

  • When price of a commodity falls it becomes relatively cheaper than other commodities.
  • As a result the consumer would like to substitute it for other commodities which have now become more expensive.
    E.g. With the fall in price of tea, coffee’s price remaining the same, tea will be substituted for coffee.
  • This is called substitution effect of the change in price of the commodity.
  • Thus, PRICE EFFECT = INCOME EFFECT + SUBSTITUTION EFFECT as explained by Hicks and Allen.

Exceptions to the Law of Demand

  • Law of Demand expresses the inverse relationship between price and quantity demanded of a commodity. It is generally valid in most of the situations.
  • But, there are some situations under which there may be direct relationship between price and quantity demanded of a commodity.

These are known as exceptions to the law of demand and are as follows:—

1. Giffen Goods:

  • In some cases, demand for a commodity falls when its price fall and vice versa.
  • In case of inferior goods like jawar, bajra, cheap bread, etc. also called “Giffen Goods” (known after its discoverer Sir Robert Giffens) demand is of this nature.
  • When the price of such inferior goods fall, less quantity is purchased due consumer’s increased preference for superior commodity with the rise in their “real income” (Le. purchasing power).
  • Hence, other things being equal, if price of a Giffen good fall its demand also falls.
  • There is positive price effect in this case.

2. Conspicuous goods:

  • Some consumers measure utility of a commodity by its price i.e. if the commodity is expensive they think it has got more utility and vice versa.
  • Therefore, they buy less at lower price and more of it at higher price.
    E.g. Diamonds, fancy cars, dinning at 5 stars, high priced shoes, ties, etc….
  • Higher prices are indicators of higher utilities.
  • A higher price means higher prestige value and higher appeal and vice versa.
  • Thus a fall in their price would lead to fall in their quantities demanded. This is against the law of demand.
  • This was found out by Veblen in his doctrine of “Conspicuous Consumption” and hence this effect is called Vebleri effect or prestige effect.

3. Conspicuous necessities:

  • The demand for some goods is guided by the demonstration effect of the consumption pattern of a social group to which the person belongs.
    E.g. Television sets, refrigerators, music systems, cars, fancy clothes, washing machines etc.
  • Such goods are used just to demonstrate that the person is not inferior to others in group.
  • Hence, inspite of the fact that prices have been continuously rising, their demand does not show tendency to fall.

4. Future changes in prices:

  • When the prices are rising, households tend to purchase larger quantities of the commodity, out of fear that prices may go up further and vice versa.
    E.g. – Shares of a good company, etc.

5. Irrational behaviour of the consumers:

  • At times consumers make IMPULSIVE PURCHASES without any calculation about price and usefulness of the product. In such cases the law of demand fails.

6. Ignorance effect:

  • Many times households may demand larger quantity of a commodity even at a higher price because of ignorance about the ruling price of the commodity in the market.

7. Consumer’s illusion:

  • Many consumers have a wrong illusion that the quality of the commodity also changes with the price change.
  • A consumer may contract his demand with a fall in price and vice versa.

8. Demand for necessaries:

  • The law of demand does not hold true in case of commodities which are necessities of life. Whatever may be the price changes, people have to consume the minimum quantities of necessary commodities. E.g.- rice, wheat, clothes, medicines, etc.

DEMAND CURVE FOR ABOVE EXCEPTIONS IS POSITIVELY SLOPED

Expansion and Contraction of Demand

(changes in quantity demanded. Or movement along a demand curve)

  • The law of demand, the demand schedule and the demand curve all show that
    – when the price of a commodity falls its quantity demanded rises or expansion takes place and
    – when the price of a commodity rises its quantity demanded fall or contraction takes place.
  • Thus, expansion and contraction of demand means changes in quantity demanded due to change in the price of the commodity other determinants like income, tastes, etc. remaining constant or unchanged.
  • When price of a commodity falls, its quantity demanded rises. This is called expansion of demand.
  • When price of a commodity rises, its quantity demanded falls. This is called contraction of demand.
  • As other determinants of price like income, tastes, price of related goods etc. are constant, the position of the demand curve remains the same. The consumer will move upwards or downwards on the same demand curve.

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Figure : Expansion and Contraction of Demand

In the figure

  • At price OP quantity demanded is OQ.
  • With a fall in price to OP1, the quantity demanded rises from OQ toOQ1,. The coordinate point moves down from E to E1This is called ‘expansion of demand’ or ‘a rise in quantity demanded’ or ‘downward movement on the same demand curve’.
  • At price OP quantity demanded is OQ.
  • With a rise in price to P2, the quantity demanded falls from OQ to OQ2. The coordinate point moves up from E to E2. This is called ‘contraction of demand’ or ‘a fall in quantity demanded’ or ‘upward movement on the same demand curve’.
  • Thus, the downward movement on demand curve is known as expansion in demand and an upward movement on demand curve is known as contraction of demand.

Increase and Decrease in demand (changes in demand OR shift in demand curve)

  • When there is change in demand due to change in factors other than price of the commodity, it is called increase or decrease in demand.
  • It is the result of change in consumer’s income, tastes and preferences, changes in population, changes in the distribution of income, etc.
  • Thus, price remaining the same when demand rises due to change in factors other than price, it is called increase in demand. Here, more quantity is purchased at same price or same quantity is purchased at higher price.
  • Likewise price remaining the same when demand falls due to change in factors other than price, it is called decrease in demand. Here, less quantity is purchased at same price or same quantity is purchased at lower price.
  • In above cases demand curve shifts from its original position to rightward when demand increases and to leftward when demand decreases. Thus, change in demand curve as a result of increase or decrease in demand, is technically called shift in demand curve.

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Figure : Increase and Decrease in Demand

In the figure

  • Original demand curve is DD. At OP price OQ quantity is being demanded.
  • As the demand changes, the demand curve shifts either to the right (D1D1) or to the left (D2D2)
  • At D1D1, OQ1, quantity is being demanded at the price OP. This shows increase in demand (rightward shifts in demand curve) due to factor other than price.
  • At D2D2, QO2 quantity is being demanded at the price OP. This shows decrease in demand (leftward shift in demand curve) due to a factor other than price.
  • When demand of a commodity INCREASES due to factors other than price, firms can sell a larger quantity at the prevailing price and earn higher revenue.
  • The aim of a advertisement and sales promotion activities is to shift the demand curve to the right and to reduce the elasticity of demand.

 

CA Foundation Business Economics Study Material – Introduction to Demand

CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Introduction to Demand

Meaning of Demand

  • In ordinary speech, the term demand is many times confused with ‘desire’ or ‘want’.
  • Desire is only a wish to have any thing.
  • In economics demand means more than mere desire.
  • Demand in economics means an effective desire for a commodity ie. desire backed by the ‘ability to pay’ and ‘willingness to pay’ for it.
  • Thus, demand refers to the quantity of a good or service that consumers are willing and able to purchase at different prices during a period of time.
  • Thus, defined, the term demand shows the following features:
    1. Demand is always with reference to a PRICE.
    2. Demand is to be referred to IN A GIVEN PERIOD OF TIME.
    3. Consumer must have the necessary purchasing power to back his desire for the commodity.
    4. Consumer must also be ready to exchange his money for the commodity he desires.
  • E.g. Mr. A’s demand for sugar at Rs. 15 per kg. is 4 kgs. per week.

Determinants of Demand

For estimating market demand for its products, a firm must have knowledge about—
(a) the determinants of demand for its product, and
(b) the nature of relationship between demand and is determinants.

The various factors on which the demand for a product/commodity depends are as follows:—

Price of the commodity:

  1. Other things being equal, the demand for a commodity is inversely related with its price.
  2. It means that a rise in price of a commodity brings about fall in its demand and vice versa.
  3. This happens because of income and substitution effects.

Price of the related commodities:

  1. The demand for a commodity also depends on the prices of related commodities.
  2. Related commodities are of two types namely—
    • Substitutes or competitive goods, &
    • Complementary goods.
  3. Substitute goods are those goods which can be used with equal ease in place of one another.
  4. E.g. Essar Speed Card and Airtel Magic Card; Coke and Pepsi; ball pen and ink pen; tea and coffee; etc.
  5. Demand for a particular commodity is affected if the price of its substitute falls or rises.
  6. E.g. If the price of Airtel Magic card falls, its demand will increase and demand for Essar Speed Card would fall and vice versa.
  7. Thus, there is a POSITIVE RELATIONSHIP between price of a commodity and demand for its substitutes.
  8. Complementary good are those goods whose utility depends upon the availability of both the goods as both are to be used together.
  9. E.g. a ball pen and refill; car and petrol; a hand set and phone connection; a tonga and horse, etc.
  10. The demand for complementary goods have an INVERSE RELATIONSHIP with the price of related goods.
  11. E.g. If the price of Scooters falls, its demand will increase leading to increase in demand for petrol.

Income of the consumers

  1. Other things being equal, generally the quantity demanded of a commodity bear a DIRECT RELATIONSHIP to the income of the consumer ie. with an increase in income, the demand for a commodity rises.
  2. However, this may not always hold true. It depends upon the class to which commodity belongs ie. necessaries or comforts and luxuries or inferior goods:
    • Necessaries (E.g. Food, clothing and shelter). Initially, with an increase in the in-come, the demand for necessaries also rises upto some limit. Beyond that limit, an increase in income will leave the demand unaffected.
    • Comforts and Luxurious (E.g. Car; Air-Conditioners; etc.) Quantity demanded of these group of commodities have a DIRECT RELATIONSHIP with the income of the consumers. As the income increases, the demand for comforts and luxuries also increases.
    • Inferior goods (E.g. Coarse grain; rough cloth; skimmed milk; etc.). Inferior goods are those goods for which superior substitutes are available Quantity demanded of this group of commodities Have an INVERSE RELATIONSHIP with the income of the consumer. E.g. A consumer starts consuming full cream milk (normal good) in place of toned milk (inferior good) with an increase in income.

Therefore, it is essential that business managers must know—

  • the nature of good they produce,
  • the nature of relationship between the quantities demanded and changes in consumer’s income, and
  • the factors that could bring about changes in the incomes of the consumers.

Tastes and Preferences of the consumers

  • Tastes and preferences of consumers generally change over time due to fashion, advertisements, habits, age, family composition, etc. Demand for a commodity bears a direct relationship to those determinants.
  • Modern goods or fashionable goods have more demand than the goods which are of old design and out of fashion.
    E.g. People are discarding Bajaj Scooter for say Activa Scooter.
  • The demand of certain goods is determined by ‘bandwagon effect’ or ‘demonstration effect’. It means a buyer wants to have a good because others have it. It means that an individual consumer’s demand is conditioned by the consumption of others.
  • Taste and preferences may also undergo a change when consumer discover that consumption of a good increases his PRESTIGE. E.g. Diamonds, fancy cars, etc.
  • A good loses its prestige when it becomes a commonly used good. This is called ‘snob effect’.
  • Status seeking rich people buy highly priced goods only. This form of ‘conspicuous consumption’ or ‘ostentatius consumption’ is called ‘VEBLEN EFFECT’ (named after American economist THORSTEIN VEBLEN)
  • Tastes and preferences of people change either due to external causes or internal causes.
  • Therefore, knowledge about tastes and preferences is important in production planning, designing new products and services to suit the changing tastes and preferences of the consumers.

Other Factors. Other things being equal demand for a commodity is also determined by the following factors:—

  1. Size and composition of Population:
    • Generally, larger the size of population of a country, more will be the demand of the commodities.
    • The composition of the population also determines the demand for various commodities.
      E.g. If the number of teenagers is large, the demand for trendy clothes, shoes, movies, etc. will be high.
  2. The level of National Income and its Distribution:
    • National Income is an important determinant of market demand. Higher the national income, higher will be the demand for normal goods and services.
    • If the income in a country is unevenly distributed, the demand for consumer goods will be less.
    • If the income is evenly distributed, there is higher demand for consumer goods.
  3. Sociological factors:
    • The household’s demand for goods also depends upon sociological factors like class, family background, education, marital status, age, locality, etc.
  4. Weather conditions:
    • Changes in weather conditions also influence household’s demand.
      E.g. – Extraordinary hot summer push up the demand for ice-creams, cold drinks, coolers etc.
  5. Advertisement:
    • A clever and continuous campaign and advertisement create a new type of demand.
      E.g. Toilet products like soaps, tooth pastes, creams etc.
  6. Government Policy:
    • The government’s taxation policy also affects the demand for commodities.
    • High tax on a commodity will lead to fall in the demand of the commodity.
  7. Expectation about future prices:
    • If consumers expect rise in the price of a commodity in near future, the current demand for the commodity will increase and vice versa,
  8. Trade Conditions:
    • If the country is passing through boom conditions, demand for most goods is more.
    • But during depression condition, the level of demand falls.
  9. Consumer-credit facility and interest rates:
    • If ample credit facilities with low rates of interest is available, there will be more demand specially of consumer durable goods like scooters, LCD /LED televisions, refrigerators, home theatre, etc.

Demand Function

Mathematical/symbolic statement of functional relationship between the demand for a product (the dependent variable) its determinants (the independent variables) is called demand function

Dx = f (Px, M, P; Pc, T, A)

Where—
Dx= quantity demanded of product
Px = the price of the product
M = money income of the consumer
Ps = the price of its substitute
Pc = the price of its complementary goods
T = consumer’s tastes and preferences
A = advertising effect measured through the level of advertisement expenditure.

CA Foundation Business Economics Study Material – Basic Problems of an Economy and Role of Price Mechanism

CA Foundation Business Economics Study Material Chapter 1 Nature and Scope of Business Economics – Basic Problems of an Economy and Role of Price Mechanism

Basic Problems of an Economy

  • We know that human wants are unlimited and resources are scarce.
  • The problem of scarcity of resources is not only faced by individuals but also by the society at large.
  • This gives rise to the problem of how to use scare resources so as to serve best the needs of the society.
  • This economic problem is to be dealt with in all the economic systems whether capitalist or socialist or mixed.
  • The central problems relating to allocation of resources are:
    • What to produce and how much to produce?
    • How to produce?
    • For whom to produce?
    • What provision should be made for economic growth?

What to produce and how much to produce?

  • An economy has millions commodities to produce.
  • It has to decide what commodities are to be produced and how much.
  • E.g. – To produce luxury goods or consumer goods, etc.
  • Here, the guiding principle is to allocate the resources in the production of goods in such a way that maximizes aggregate utility.

How to produce ?

  • There are many alternative techniques to produce a commodity. ‘
  • Choice has to be made between capital intensive technique or labour intensive technique of production.
  • The choice of technique will depend upon —
    • availability of various factors of production, &
    • the prices of factors of production.
  • Such techniques of production has to be adopted that makes best use of available resources.

For whom to produce?

  • Who will consume the goods and services that are produced in the economy?
  • Whether a few rich or many poor will consume?
  • Goods and services are produced for those people who can purchase them or pay for them.
  • Paying capacity depends upon income or purchasing power.

What provisions should be made for economic growth?

  • A society cannot afford to use all its scarce resources for current consumption only.
  • It has to provide for the future as well so that high economic growth can be achieved.

Therefore, an economy has to take decisions about rate of savings, investment, capital formation, etc.

Meaning of Economic System

An economic system comprises the totality of forms through which the day to day economic process is at work. It refers to the mode of production, exchange, distributions and the role which government play in economic activity. There are three types of economic systems Capitalism, Socialism and Mixed Economy ‘

CAPITALIST ECONOMY

  • Capitalistic economic systems is one in which all the means of production are privately owned.
  • The owners of property, wealth and capital are free to use them as they like in order to earn profits.
  • The central problems about what, how and for whom to produce are solved by the free play of market forces.

Characteristics of Capitalist Economy:

  • There is right to own and keep private property by individuals. People have a right to acquire, use, control, enjoy or dispose off it as they like.
  • There is right of inheritance ie. transfer of property of a person to his legal heirs after his death.
  • There is freedom of enterprise ie. everybody is free to engage in any type of economic activity he likes.
  • There is freedom of choice by consumers ie. consumer is free to spend his income on whatever goods or services he wants to buy and consume.
  • Entrepreneurs or producers in their productive activity are guided by their profit motive. Thus profit motive is the guiding force behind all the productive activity.
  • There is stiff competition among sellers or producers of similar goods. There is competition among all the participants in the market.
  • Price mechanism is an important feature of capitalist economy were the price is determined through the interaction of market forces of demand and supply.

Merits of Capitalist Economy:

  • Capitalism works through price mechanism and hence self regulating
  • In capitalism there is greater efficiency and incentive to work due to two motivating force namely private property and profit motive.
  • Faster economic growth is possible.
  • There is optimum allocation of productive resources of the economy.
  • There is high degree of operative efficiency.
  • Cost effective methods are employed in order to maximise profits.
  • Consumers are benefited as large range of quality goods at reasonable prices are available from which they makes the choice. This also results in higher standard of living.
  • In capitalism there is more innovations and technological progress and country benefits from research and development, growth of business talent, etc.
  • Fundamental rights like right to private property and right to freedom are preserved.
  • It leads to emergence of new entrepreneurial class who is willing to take risks.

Demerits of Capitalist Economy:

  • In capitalism there is vast economic inequality and social injustice which reduces the welfare of the society.
  • There is precedence of property rights over human rights.
  • Cut-throat competition and profit motive work against consumer welfare leading to exploitation of consumers.
  • There are wastage of resources due to duplication of work and cut-throat competition.
  • Income inequalities lead to differences in economic opportunities. This lead to rich becoming richer and poor becoming poorer.
  • There is exploitation of labour.
  • More of luxury goods and less of wage goods are produced leading to misallocation of resources. .
  • Unplanned production, economic instability in terms of over production, depression, unemployment, etc. are common in a capitalist economy.
  • Leads to creation of monopolies.
  • Ignores human welfare because main aim is profit.

SOCIALIST ECONOMY

The concept of socialism was given by Karl Marx and Frederic Engels in their work ‘The Communist Manifesto’ published is 1848. A socialist economy is also called as “Command Economy” or a “Centrally Planned Economy.”

  • In a socialist economy, all the property, wealth and capital is owned by State. There is no private property.
  • State organises all economic activities. It owns, controls and manages the production units; it distributes the goods among the consumers; it decides the size and direction of investment.
  • The state works for the welfare of the people and not for profit.

Characteristics of Socialist Economy:

  • There is collective ownership of means of production Le. all the important means of production are state owned.
  • It is a centrally planned economy. All the basic decisions relating to the working and the regulation of the economy are taken by central authority called planning commission.
    • Production and distribution of goods is ensured through planning on preferences deter-mined by the state. So freedom from hunger is guaranteed but, consumer’s sovereignty is restricted.
  • There is social welfare in place of profit motive. Those goods and services are given top priority which is in the interest of largest number of people.
    • Price policy is guided by the aims of social welfare than profit motive.
  • There is lack of competition because it avoid duplication of efforts and wastage of resources. Hence, competition is done away.
  • Socialism tries to ensure equitable distribution of income through equality of opportunities. Thus, right to work is guaranteed but choice of occupation is restricted.

Merits of Socialist Economy:

  • Social justice is maintained by equitable distribution of income and wealth and by providing equal opportunities to all.
  • Balanced economic development is possible. Central planning authority allocate resources according to the plans and priorities.
  • There are no class conflict and community develops a co-operative mentality.
  • Unemployment is minimized, business fluctuations are eliminated resulting in stability.
  • Right to work is ensured and minimum standard of living is maintained.
  • There is no exploitation of consumers and workers.
  • Wastage of resources are avoided due to planning resulting in better utilization of resources and maximum production.
  • Citizens feel secure as there is social security cover for them.
  • Demerits of Socialist Economy:
  • There is predominance of bureaucracy resulting in inefficiency and delays.
  • There is no freedom of individuals as it takes away basic rights also like right of private property.
  • Workers are not paid according to their personal efficiency and productivity. This acts as disincentive to work hard.
  • Prices are administered by the state.
  • State monopolies may be created and may become uncontrollable. This will be more dan¬gerous than monopolies under capitalism.
  • The consumers have no freedom of choice.

MIXED ECONOMY

Mixed economy combines the features of both capitalism and socialism. The concept is designed to incorporate best of both. The main characteristics/features are:—

  • There is co-existence of both private and public sector ie. economic resources are owned by individuals and state.
    • State open those enterprises which are in the interest of the’society as a whole.
    • Private sector moves to those enterprises which produce higher profit.
  • There is co-existence of free price mechanism and economic planning.
    • Price mechanism is however curtailed through measures like price control, administered prices etc.
    • Planning is done through incentives like concessions, subsidies, etc. and disincentives like high rate of taxes, strict licensing etc.
  • In mixed economy social welfare motive gets due importance particularly in case of poor and backward classes.
    Eg. Subsidised hospital, food articles, education etc.; social security schemes like old age pension, reservation of jobs, laws in the interest of workers, consumers, human, children etc.
  • There is freedom to joint any occupation, trade or service according to the education, training, skills and ability.
  • There is freedom of consumption. People are free to consume goods and services of their choice and in the quantity they can afford.

Merits of Mixed Economy:

  • Merits of capitalist economy and socialist economy are found in mixed economy.
  • There is right of private property and economic freedom. This results in incentive to work hard and capital formation.
  • Price mechanism and competition induces the private sector in efficient decision making and better resource allocation.
  • There is freedom of occupation and consumption.
  • Encourages enterprise and risk taking.
  • Leads to development of technologies through research and development.
  • Economic and social equality is more.

However, mixed economy suffers from uncertainties, excess control by state, poor implementation of plans, high taxes, corruption, wastage of resources, slow growth, lack of efficiency, etc. There are possibilities of private sector growing, disproportionately if state does not maintain a proper balance between public and private sectors.

CA Foundation Business Economics Study Material – Nature and Scope of Business Economics

CA Foundation Business Economics Study Material – Nature and Scope of Business Economics

Nature of Business Economics

The subject matter of Economics is broadly divided into two major parts namely:—
Micro-Economics, and Macro-Economics
Before dealing with nature of Business Economics, it is necessary to understand the difference between the two.

1. Micro-Economics – Micro means a ‘small part’. Therefore, Micro-economics study the behaviour of small part or a small component or different individuals and organisations of a national economy. It examines how the individual units take decision about rational allocation of their scarce resources.

Micro-Economics covers the following:

  • Theory of Product Pricing;
  • Theory of Consumer Behaviour,
  • Theory of Factor Pricing;
  • The economic conditions of a section of people;
  • Behaviour of firms; and
  • Location of industry.

2. Macro-Economics – Macro means ‘large’. Therefore, macro-economics deals with the large economic activity. It study the economic system of a country as a whole ie. overall condition of an economy. It is a study of large aggregates like total employment, the general price level. Total output, total consumption, total saving and total investments. It also analyses how these aggregates change over time.

Macro-Economics covers the following:

  • National Income and National Output;
  • The General Price Level and interest rates;
  • Balance of Trade and Balance of Payments;
  • External value of currency ie. exchange rate;
  • Overall level of savings and investments ie. capital formation; and
  • The level of employment and rate of economic growth.

Business Economics is primarily concerned with Micro-Economics. However, knowledge and understanding of Macro-economic environment is also necessary. This is because macro-economic environment influence individual firm’s performance and decisions.

As already seen Business Economics enables application of economic knowledge, logic, theories and analytical tools. It is Applied Economics that fills the gap between economic theory and business practice. The following will describe the nature of Business Economics:

  1. Business Economics is a Science: Science is a systematised body of knowledge which trace the cause and effect relationships. Business Economics uses the tools of Mathematics, Statistics and Econometrics with economic theory to take decisions and frame strategies. Thus, it makes use of scientific methods.
  2. Based on Micro-Economics: As Business Economics is concerned more with the decision making problems of a particular business establishment. Micro level approach suits is more. Thus, Business Economics largely depends on the techniques of Micro-Economics.
  3. Incorporates elements of Macro Analysis: A business unit is affected by external environment of the economy in which it operates. A business units is affected by general price level, level of employment, govt, policies related to taxes, interest rates, industries, exchange rates, etc. A business manager should consider such macro-economic variables which may affect present or future business environment.
  4. Business Economics is an Art: It is related with practical application of laws and principles to achieve the objectives.
  5. Use of Theory of Markets & Private Enterprise: It uses the theory of markets and resource allocation in a capitalist economy.
  6. Pragmatic Approach: Micro-Economics is purely theoretical while, Business Economics is practical in its approach.
  7. Inter-disciplinary in nature: It incorporates tools from other disciplines like Mathematics, Statistics, Econometrics, Management Theory, Accounting, etc.
  8. Normative in Nature: Economic theory has been developed along two lines – POSITIVE and NORMATIVE.

A positive science or pure science deals with the things as they are and their CAUSE and EFFECTS only. It states ‘what is’? It is DESCRIPTIVE in nature. It does not pass any moral or value judgments.

A normative science deals with ‘what ought to be’ or ‘what should be’. It passes value judgments and states what is right and what is wrong. It is PRESCRIPTIVE in nature as it offers suggestions to solve problems. Normative science is more practical, realistic and useful science.

Business Economics is normative in nature because it suggests application of economic principles to solve problems of an enterprise, However, firms should have clear understanding of their environment and therefore, it has to study positive theory.

Scope of Business Economics

The scope of Business Economics is wide. Economic theories can be directly applied to two types of business issues namely—

  1. Micro-economics is applied to operational or internal issues off a firm.
  2. Macro-economics is applied to environment or external issues on which the firm has no control.

1. Micro-economics applied to operational or internal issues
Issues like choice of business size of business, plant layout, technology, product decisions, pricing, sales promotion, etc. are dealt by Micro-economic theories. It covers—

  • Demand analysis and forecasting
  • Production and Cost Analysis
  • Inventory Management
  • Market Structure and Pricing Analysis
  • Resource Allocation
  • Theory of Capital and Investment Decisions
  • Profitability Analysis
  • Risk and Uncertainty Analysis.

2. Macro-economics applied to environmental or external issues
The major economic factors relate to—

  • the type of economic system
  • stage of business cycles
  • the general trends in national income, employment, prices, saving and investment.
  • government’s economic policies
  • working of financial sector and capital market
  • socio-economic organisations
  • social and political environment.

These external issues has to be considered by a firm in business decisions and frame its policies accordingly to minimize their adverse effects.

CA Foundation Business Economics Study Material – Introduction

CA Foundation Business Economics Study Material Chapter 1 Nature and Scope of Business Economics – Introduction

WHAT IS ECONOMICS ABOUT?

The word ‘Economics’ is derived from the Greek word ‘Oikonomia’ which means household management. Till 19th century, economics was known as ‘Political Economy’. In 1776, Adam Smith published his book entitled “An Inquiry into the Nature and Causes of the Wealth of Nations” which is considered as the first modern work of Economics.

Every individual, every society and every country in this world faces the problem of making CHOICE. This is because of two facts—

  • Human wants are unlimited; and
  • The means (resources) to satisfy unlimited wants are relatively scarce and these scarce resources have alternative uses.

As a result we are confronted with the problem of making choice of wants to be satisfied or the choice among the uses of resources. Thus, we are faced with the problem of allocation of resources to various uses.

The definition of Economics is however is narrow because it concentrates only at present i.e., how to use relative scarce resources to satisfy unlimited human wants. So it gives the picture of a society with fixed resources, skills and productive capacity, deciding what type of goods and services to be produced and how to distribute among the members of society.

However, over a period of time growth takes place. With growth there is increase in the resources and improvement in the quality of resources. But this growth in production and income is not smooth. It is through ups and downs. Economics, therefore, deals not only with how a country allocates its scarce productive resources but also with increase in the productive capacity of resources and with the reasons which led to sharp fluctuations in the use of resources.

Economics gives us understanding on economic issues like changes in the price of a commodity, changes in general price level of goods and services, poverty, level of unemployment, etc. The understanding of such helps us to decide the models and frameworks that can be applied in different situations. The tools of economics helps us to choose the best course of action from various alternatives available. However, economic problems are of complex nature and are affected by economic forces, political set-up, social norms, etc. Thus, economics does not guarantee that all problems will be solved appropriately but it helps us to examine the problem in right perspective and find suitable measures to deal with it.

Meaning of Business Economics

  • Business Economics is also referred to as Managerial Economics. It is application of economic theory and methodology.
  • Every business involves decision-making as survival and success depends on sound decisions.
  • Decision making means the process of –
    • evaluating various course of action,
    • making rational judgment on the basis of available information, and
    • selecting i.e. making choice of a suitable alternative by decision maker.
  • Decision making is not simple and straight forward. It has become very complex due to ever changing business environments, growing competition, large scale production, big size of business houses, complex laws, cost awareness, etc. In other words the economic environment in which the firm operates is very complex and dynamic.
  • Business Economics provides a scientific base to the professional management of a business activity. It provides tools like budgeting, market analysis, cost-benefit analysis, etc. which can be scientifically applied to take sound business decisions. Thus, Business Economics is a sub-branch of Economics which aims at the scientific application of economic knowledge, logic, theories and tools to take rational business decisions. Thus, it is an APPLIED ECONOMICS.
  • Business Economics is closely connected with both viz., Micro-Economic Theory as well as Macro-Economic Theory. It is also useful to the managers of ‘not-for-profit’ organisations.

DEFINITIONS OF BUSINESS ECONOMICS

  • “Business Economics in terms of the use of economic analysis in the formulation of business policies. Business Economics is essentially a component of Applied Economics as it includes application of selected quantitative techniques such as linear programming, regression analysis, capital budgeting, break-even analysis and cost analysis.” – Joel Dean
  • “Business Economics is concerned with the application of economic laws, principles and methodologies to the managerial decision making process within a business firm under the conditions of risks and uncertainties.” – Evans Douglas