ENGINEERING ECONOMICS AND

ACCOUNTANCY

Lavanya.K
Assistant Professor
MRIT-MBA
 UNIT- I

 Introduction to Engineering Economics

 Basic Principles and Methodology of Engineering
Economics
 Fundamental Concepts- Demand
 Demand Determinants
 Law of Demand
 Demand Forecasting and Methods
 Elasticity of Demand
 Theory of Firm
 Supply
 Elasticity of Supply.
Introduction to Engineering Economics

 Engineering is the profession in which knowledge of the mathematical and

natural sciences gained by study experience and practice is applied with
judgment to develop ways to utilise economically the material and forces of
nature for the benefit of mankind.

 Engineering Economics is a subject of vital importance to Engineers. This

subject helps one understand the need for the knowledge of Economics for
being an effective manager and decision maker.

 The Economics theories are used to take decisions related to uncertain and
changing business environment. Economics theories deal with the principles of
demand, pricing, cost, production, competition, trade cycles, and national
income and so on.
 As the design and manufacturing process become more complex, the engineer is
making decisions that involve money more than ever before. The competent and
successful engineer at present must have an improved understanding of the
principles of economics. The engineering economics is concerned the systematic
evaluation of the benefits and costs of projects involving engineering design and
analysis.

 Engineering economics quantifies the benefits and costs associating with

engineering projects to determine if they save enough money to warrant their
capital investments. Engineering economics requires the application of
engineering design and analysis principles to provide goods and services that
satisfy the consumer at an affordable cost. Engineering economics is also
relevant to the design engineer who considers material selection.
 Engineering economics involves the systematic evaluation of the economic
benefits of proposed solutions to engineering problems. The engineering
economics involves technical analysing with emphasis on the economic aspects
and has the objective of assisting decisions.

 Engineering economics is closely aligned with Conventional Micro-Economics.

It is devoted to problem solving and decision making at the operational level.
Thus “Engineering Economics refers to those aspects of economics and its
tools of analysis most relevant to the Engineer’s decision making process”.
 Characteristics of Engineering Economics

For the clear understanding of the subject matter one must have the knowledge of
the special characteristics of Engineering Economics:

 Engineering Economics is closely aligned with Conventional Micro-Economics.

 Engineering Economics is devoted to the problem solving and decision making
at the operations level.
 Engineering Economics can lead to sub-optimisation of conditions in which a
solution satisfies tactical objectives at the expense of strategic effectiveness.

 Engineering Economics is useful to identify alternative uses of limited

resources and to select the preferred course of action.
 Engineering Economics is pragmatic in nature. It removes complicated abstract
issues of economic theory.
 Engineering Economics mainly uses the body of economic concepts and
principles.
 Engineering Economics integrates economic theory with engineering practice.
Basic Principles and Methodology of Engineering Economics

Principles of Engineering Economy

1.Develop the Alternatives

2. Focus on the Differences

3. Use a Consistent Viewpoint

4. Use a Common Unit of Measure

5. Consider All Relevant Criteria

6. Make Uncertainty Explicit

7. Revisit Your Decisions

 Develop the Alternatives The final choice (decision) is among alternatives.
The alternatives need to be identified and then defined for subsequent
analysis.
 Focus on the Differences Only the differences in expected future outcomes
among the alternatives are relevant to their comparison and should be
considered in the decision.

 Use a Consistent Viewpoint The prospective outcomes of the alternatives,

economic and other, should be consistently developed from a defined
viewpoint (perspective).
 Use a Common Unit of Measure Using a common unit of measurement to
enumerate as many of the prospective outcomes as possible will make easier
the analysis and comparison of alternatives.
 Consider All Relevant Criteria Selection of a preferred alternative (decision
making) requires the use of a criterion (or several criteria).

 Make Uncertainty Explicit Uncertainty is inherent in projecting (or estimating)

the future outcomes of the alternatives and should be recognized in their analysis
and comparison.

 Revisit Your Decisions Improved decision making results from an adaptive

process; to the extent practicable, the initial projected outcomes of the selected
alternative should be subsequently compared with actual results achieved.
 Fundamental Concepts- Demand

 Demand is the quantity of goods and services that customers are willing and able to
purchase during a specified period under a given set of economic conditions. The
period here could be an hour, a day, a month, or a year. The conditions to be
considered include the price of good, consumer’s income, the price of the related
goods, consumer’s preferences, and advertising expenditures and so on.
 Demand is an economic principle that describes the willingness and desire of
consumers to purchase specific goods or services at a specific Ceteris Paribus (all
other things being unchanged or constant).
 For a new company, the demand analysis can tell whether a substantial demand
exists for the product/service and given the other information like number of
competitors, size of competitors, industry growth etc it helps to decide if the
company could enter the market and generate enough returns to sustain and advance
its business.
DETERMINANTS OF DEMAND

The demand for a commodity by a buyer is generally not a fixed quantity. It is

affected by many factors. The factors that influence the demand are called the
determinants of demand. The determinants of demand are also known as demand
shifters. The following factors affect an individual’s demand for a commodity.
1.Price of Commodity
2.Other factors which include:
a) Income of the consumer
b) Consumer tastes and preferences
c) Prices of related goods
d) Expectations of future price changes
e) Advertising efforts
f) Quality of the product
g) Distribution of income and wealth in the community
h) Standard of living and spending habits
i)Population
j) Level of taxation and tax structure
k) Climate or weather conditions
l) Population
Other Factors
a) Income of the Consumer: Price of Commodity remaining the same, an increase
in the income of its buyer increases his purchasing power. In case of a normal good
or superior good, there is a direct relationship between the income of its buyer and
his demand for it. In case of inferior goods, there is an inverse relationship between
the income of its buyer and his demand for it.

b) Consumer Tastes and Preferences: The demand for a good is also affected by
the tastes and preferences of its buyer. If a consumer no longer likes a commodity,
he/she will not buy it or may buy less of it. An increased taste in a product increases
its demand. A decreased taste in a product decreases its demand.
c) Expectations of Future Price Changes: If people expect prices to rise in the
near future, they will try to buy more now in order to avoid paying a higher price
later and vice versa. If consumers expect a price increase in near future, demand
increases and If consumers expect a price decrease in the near future, demand
decreases.

d) Advertisement: A firm can influence the buying behavior of consumers through

advertisement. Allocation of more budget for advertisement leads to more demand
whereas Allocation of less budget for advertisement leads to less demand.

e) Quality of the Product: High quality of the product leads to high demand
whereas Low quality of the product leads to less demand.
f)Distribution of Income and Wealth in the community: Equal distribution of
income and wealth leads to greater demand and Unequal distribution of income
and wealth leads to lesser demand.

g) Standard of Living and Spending Habits: High standard of living leads to

high demand for comfort and luxury products and low standard of living leads to
low demand for comfort and luxury products.

h) Age structure and sex ratio of Population: More population of females leads
to high demand for female-used products and less population of females leads to
low demand for female-used products.
i) Level of Taxation and Tax structure: High tax rate leads to low demand for
goods whereas Low tax rate leads to high demand for goods

j) Climate and Weather Conditions: During a particular season, there is more

demand for seasonal products and during an off-season, there is less demand for
seasonal products.

k) Population: More consumers increase the product’s demand and fewer

consumers decrease the product’s demand.
 Law of Demand

The consumer’s decisions are guided by several elements, such as price, income,
tastes and preferences etc. Among the many causal factors affecting demand, price is
the most significant and the price- quantity relationship called as the Law of
Demand is stated as follows:
“The greater the amount to be sold, the smaller must be the price at which it is
offered in order that it may find purchasers, or in other words, the amount demanded
increases with a fall in price and diminishes with a rise in price”. In simple words
other things being equal, quantity demanded will be more at a lower price than
at higher price. The law assumes that income, taste, fashion, prices of related
goods, etc. remain the same in a given period.
The law indicates the inverse relation between the price of a commodity and its
quantity demanded in the market.
Exceptions to the Law of Demand
The law of demand is widely applicable to a large number of goods. However, there
are certain exceptions to it on account of which a change in the price of a good does
not lead to a change in its quantity demanded in the opposite direction.

1. Inferior Goods: Some goods are consumed generally by poorer sections of the
society. It is believed that with an increase in income such a consumer should move
to a ‘better’ quality substitute good. For example, with an increase in income, a
typical poor consumer shifts his demand from coarse grains to finer varieties of
cereals. Therefore, with a fall in the price of a good (more so a necessity on which
the consumer is spending a large part of his budget), the real income of the consumer
goes up. If, he considers the good under consideration an inferior good, he reduces
its demand and buys more of its substitute(s).
2.Giffen Goods: Some special varieties of inferior goods are termed as Giffen
goods. Cheaper varieties of this category like bajra, cheaper vegetable like potatoes
come under this category.
Sir Robert Giffen of UK first observed that people used to spend more their income
on inferior goods like potato and less of their income on meat. But potatoes
constitute their staple food. When the price of potato increased, after purchasing
potato they did not have so many surpluses to buy meat. So the rise in price of
potato compelled people to buy more potato and thus raised the demand for potato.

This is against the law of demand. This is also known as Giffen paradox. So giffen
goods are products that people continue to buy even at high prices due to lack of
substitute products.
3.Veblen Goods: A Veblen good is a luxury item whose price does not follow the
usual laws of supply and demand. Usually, the higher the price of a particular good the
less people will want it. For luxury goods, such as very expensive wines, watches or
cars, however, the item becomes more desirable as it grows more expensive and less
desirable should it drop in price. Veblen goods are named after the American
economist and sociologist Thorstein Veblen. Veblen goods are not to be confused with
Giffen goods which also rise in demand as they grow more expensive. Far from being
luxury items Giffen goods tend to be staple food items, the increased demand for
which is fuelled by poverty.
4.Ignorance: In some cases, the consumers suffer from the false notion that a higher
priced good is of better quality. This happens mainly in the case of those goods where
a typical consumer is not able to judge the quality easily. In such cases, the sellers
may be able to sell more not by lowering the price but by raising it.
5.Conspicuous Consumption: Certain goods are meant for adding to one’s social
prestige. These form the part of ‘status symbol’ for showing that their user is a
wealthy or cultured person. The consumers consider it as a distinction to have these
goods. In other words, a commodity may be purchased not because of its intrinsic
value but because it is expected to add to the social prestige of the buyer. For
example: Diamonds and expensive jewellery, expensive carpets. Their demand falls,
if they are inexpensive
6.Change in Fashion: A change in fashion and tastes affects the market for a
commodity. When a broad toe shoe replaces a narrow toe, no amount of reduction in
the price of the latter is sufficient to clear the stocks. Broad toe on the other hand,
will have more customers even though its price may be going up. The law of
demand becomes ineffective.
7.Complementary Goods: Law of demand may be violated in the case of
complementary goods also. For example: if the price of the DVD player falls leading
to increase in its demand, in spite of rise in price of DVDs, their demand will
increase.
 Demand Forecasting and Methods

Introduction:
The information about the future is essential for both new firms and those planning
to expand the scale of their production. Demand forecasting refers to an estimate of
future demand for the product.
It is an ‘objective assessment of the future course of demand”. In recent times,
forecasting plays an important role in business decision-making. Demand
forecasting has an important influence on production planning. It is essential for a
firm to produce the required quantities at the right time.
It is essential to distinguish between forecasts of demand and forecasts of sales.
Sales forecast is important for estimating revenue cash requirements and expenses.
Demand forecasts relate to production, inventory control, timing, reliability of
forecast etc. However, there is not much difference between these two terms.
 METHODS OF DEMAND FORECASTING

There are many methods of forecasting demand. To forecast demand, we need

to build a certain base of information. To build such an information base, we
need to consider what the customers say, what the customers do, and how the
customers behaved in a given marketing situation. The different methods of
forecasting demand can be grouped under
(a) survey methods
(b) statistical methods and
(c) Other methods
1) Survey methods
a) Survey of buyer intentions
Census method
Sample method
b) Sales force opinion method
2) Statistical methods
a) Trend projection method
 Trend line by observation
 Least square method
 Time series analysis
 Moving averages method
b) Exponential smoothing
c) Barometric techniques
d) Simultaneous equations method
e) Correlation and regression methods
3) Other methods
 Expert opinion method
 Test marketing
 Controlled experiments
 Judgments approach
1. Survey Methods
a) Survey of Buyers Intentions: TO anticipate what buyers are likely to do under
a given set of circumstances? A most useful source of information would be the
buyers themselves. It is better to draw a list of all potential buyers, approach
each buyer to ask how much does he plans to buy of the given product at a given
point of time under particular conditions.
This is the most effective method because the buyer is the ultimate decision maker
and we are collecting the information directly from him.
The survey of buyers can be conducted either by covering the population or by
selecting a sample group of buyers. Suppose there are 10,000 buyers for a particular
product. If the company wishes to elicit the opinion of all the buyers. This method is
called census method or total enumeration method.
This method is not only time consuming, but also costly. On the other hand, the
firm can select a group of buyers who can represent the whole population. This
method is called the sample method. A survey of buyers based on sample basis can
be completed faster with relatively lower costs.

Surveys of this nature focus directly on the consumer requirements and their
behaviour. They look more simple and easy to be administered when compared to
other statistical techniques such as trend analysis and econometric methods such as
regression analysis.
b) Sales Force Opinion method: Sales Force Opinions Another source of
getting reliable information about the possible level of sales or demand for a
given product or service is the group of people who sell the same. Thus, we can
control the limitations of cost and delays in contacting the customers.

The sales people are those who are in constant touch with the main and large
buyers of a particular market, and hence they constitute another valid source of
information about the likely sales of a product. The sales force is capable of
assessing the likely reactions of the customers of their territories quickly, given
the company’s marketing strategy; It is less costly as the survey can be conducted
instantaneously through telephone, fax or video conferencing, and so on. The
data, thus collected, forms another valid source of reliable information.
Here also, there is a danger that salesman may sometimes become biased in
their views. The sales people are paid based on their results. Where the targets
are set based on the results of the survey of the sales force, and the payment is
linked to achievement of these targets, incentive is paid to those who achieve
more than their targets. To prevent the company from fixing higher targets, it is
quite likely that they understate or overstate the demand to eventually get how
or high sales quota set for them.
2. Statistical Methods: For forecasting the demand for goods and services in th
long run , statistical and mathematical methods are used considering th past data.
a) Trend Projection Methods: These are generally based on analysis of past
sales patterns. These methods dispense with the need for costly market research
because the necessary information is often already available in company files in
terms of different time periods, that is, a time series data. There are five main
techniques of mechanical extra pollution. In extrapolation, it is assumed that
existing trend will maintain all through.
Trend line by observation: This method of forecasting trend is elementary, easy
and quick as it involves merely the plotting the actual sales data on a chart and
then estimating just by observation where the trend line lies. The line can be
extended towards a future period and corresponding sales forecast read from the
graph.
Least Squares Method: Certain statistical formulae are used here to find the trend
line which ‘best fits’ the available data. The trend line is the basis to extrapolate the
line ofr future demand for the given product or service on graph. Here it is assumed
that there is a proportion change in sales over a period of time. In such a case , the
trend line equation is in linear form. Where this assumption does not hold a good, the
equation can be in non linear form.
The estimating linear trend equation of sales is written as:

Where x and y have been calculated from past data S is sales and T is the year number
for which the forecast is made. To find the values of x and y, the following normal
equations have to be stated and solved:
Where
S is the sales ;
T is the year number ,
n= number of years
Time series analysis: Where the surveys or market tests are costly and time
consuming, statistical and mathematical analysis of past sales data offers another
method to prepare the forecasts , that is, time series analysis . One major
requirement to administer this technique is that the product should have actively
been traded in the market for quite some time in the past. In other words,
considerable data on the performance of the product or service over significantly
large period should be available for better results under this method. Time series
emerge from such a data when arranged chronologically .Given significantly
large data, the cause and effect relationships can be discovered through
quantitative analysis.
Moving average method: This method considers that the average of past events
determines the future events. In other words, this method provides consistent
results when the past events are consistent and unaffected by wide changes. AS
the name itself suggests, under this method, the average keeps on moving
depending up on the number of years selected. Selection of the number of years is
the decisive factor in this method. Moving averages get updated as new
information flows in.
This method is easy to compute. One major advantage with this method is that the
old data CAN be dispensed with, once the averages are computed. These averages,
not the original data, are further used as the forecast for next period.
Exponential smoothing: This is a more popular technique used for short run
forecasts. This method is an improvement over moving averages method. Unlike
in moving averages method, all time periods here are given varying weights, that
is m the values of the given variable in the recent times are given higher weights
and the values of the given variable in the distant past are given relatively lower
weights for further processing.
The formula used for exponential smoothing is
St+1 = cSt + (1-c)Smt
Where
St+1 is exponentially smoothed average for nw year

St is actual data in the most recent past

Smt is most recent smoothed forecast

c is smoothing constant
b) Barometric Techniques: Where forecasting base d on time series analysis or
extrapolation may not yield significant results, barometric techniques can be made
use of. Under the barometric technique, one set of data is used to predict another set
. In other words, to forecast demand for a particular product or service, use some
other relevant indicator of future demand.

c) Simultaneous equation method:In this method, all variables are simultaneously

considered, with the conviction that every variable influences the other variable in
an economic environment. Hence, the set of equations equal the no of dependent
(controllable) variable which is also called endogenous variable. In other words, it
is a system of ‘n’ equations with ‘n’ unknowns. It can be solved; the moment of the
model is specified because it covers the entire unknown variable it is also called
complete system approach to demand forecasting.
d) Correlation and regression methods: Correlation and regression methods are
statistical techniques. Correlation describes the degree of association of between
two variables such as sales and advertisement expenditure. When the two variables
tend to change together, then they are set to be correlated. The extent to which they
are correlated is measured by correlation coefficient. Of these two variables, one is
a dependent variable and another is the independent variable. If the high vales of
one variable are associated with the high value of another, they are set to be
positively correlated. Correlation coefficient ranges between +1 and -1. It does not
exceed this range. Where the correlation coefficient is zero, it indicates that the
variables under the study are not related at all.
In regression analysis, an equitation is estimated which best fits in the sets of
observations of depended variables and independent variables.
3) OTHER METHODS

Expert Opinion: Well informed persons are called experts. Experts constitutes at
another source of information. These persons are generally the outside experts and
they do not have any vested interests in the results of a particular survey. An
experts is good at forecasting and analyzing the feature trends in a given product or
service at a given level of technology.

Test marketing: It is likely that opinions given by buyers, sales man or other
expert may be, at times, misleading. This is the reason why most of the
manufacturers favor to test their product or service in limited market as test run
before they launch their product nationwide.
Controlled Experiments: Controlled experiments refer to such exercises where
some of the major determinants of demand are manipulated to suit to the
customers with the different tastes and preferences, income groups, and such
others. It is further assumed that all other factor remain the same. In this method,
the product is introduced with different packages, different prices in different
markets or same markets to assess which combination appeals to the customer
most.

Judgmental approach: When none of the above methods are directly related to
the given product or service, the management has no alternative other than using
its own judgment.
 ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and
consequent change in amount demanded. “Marshall” introduced the concept of
elasticity of demand. Elasticity of demand shows the extent of change in quantity
demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small
according as the amount demanded increases much or little for a given fall in the
price and diminishes much or little for a given rise in Price”
Elastic demand: A small change in price may lead to a great change in quantity
demanded. In this case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in
demanded then the demand in “inelastic”.
Types and Measurements of Elasticity of Demand:
There are different types of elasticity of demand:

 Price elasticity of demand

 Income elasticity of demand
 Cross elasticity of demand
 Advertising elasticity of demand
1. Price elasticity of demand:
Marshall was the first economist to define price elasticity of demand. Price
elasticity of demand measures changes in quantity demand to a change in Price. It is
the ratio of percentage change in quantity demanded to a percentage change in
price.

Proportionate change in the quantity demand of commodity

Price elasticity = ------------------------------------------------------------------
Proportionate change in the price of commodity

Edp = (Q2 - Q1) / Q1

-------------
( P2 - P1) / P1
There are five cases of price elasticity of demand
A. Perfectly elastic demand: When small change in price leads to an
infinitely large change is quantity demand, it is called perfectly or
infinitely elastic demand. In this case E=∞

P D D1

0 X
The demand curve DD1 is horizontal straight line. It shows the at “OP”
price any amount is demand and if price increases, the consumer will not
purchase the commodity.
A. Perfectly Inelastic Demand: In this case, even a large change in price
fails to bring about a change in quantity demanded.

When price increases from ‘OP’ to ‘OP’, the quantity demanded remains
the same. In other words the response of demand to a change in Price is
nil. In this case ‘E’=0.
A. Relatively elastic demand: Demand changes more than proportionately
to a change in price. i.e. a small change in price loads to a very big change
in the quantity demanded. In this case E > 1. This demand curve will be
flatter.

When price falls from ‘OP’ to ‘OP’, amount demanded in crease from “OQ’
to “OQ1’ which is larger than the change in price.
A. Relatively in-elastic demand: Quantity demanded changes less than
proportional to a change in price. A large change in price leads to small
change in amount demanded. Here E < 1. Demanded carve will be steeper.

When price falls from “OP’ to ‘OP1 amount demanded increases from OQ
to OQ1, which is smaller than the change in price.
 A. Unit elasticity of demand: The change in demand is exactly equal to the
change in price. When both are equal E=1 and elasticity if said to be
unitary.

When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to
‘OP1’, quantity demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price
has resulted in an equal change in quantity demanded so price elasticity of
demand is equal to unity.
2. Income elasticity of demand:
Income elasticity of demand shows the change in quantity demanded as a result of a
change in income. Income elasticity of demand may be slated in the form of a
formula.

Proportionate change in the quantity demand of commodity

Income Elasticity = ------------------------------------------------------------------
Proportionate change in the income of the people

Income elasticity of demand can be classified in to five types.

 A. Zero income elasticity: Quantity demanded remains the same, even
though money income increases. Symbolically, it can be expressed as Ey=0.
It can be depicted in the following way:

As income increases from OY to OY1, quantity demanded never changes.

A. Negative Income elasticity: When income increases, quantity demanded
falls. In this case, income elasticity of demand is negative. i.e., Ey < 0.

When income increases from OY to OY1, demand falls from OQ to OQ1.

A. Unit income elasticity: When an increase in income brings about a
proportionate increase in quantity demanded, and then income elasticity
of demand is equal to one. Ey = 1

When income increases from OY to OY1, Quantity demanded also

increases from OQ to OQ1.
A. Income elasticity greater than unity: In this case, an increase in come
brings about a more than proportionate increase in quantity demanded.
Symbolically it can be written as Ey > 1.

It shows high-income elasticity of demand. When income increases from

OY to OY1, Quantity demanded increases from OQ to OQ1.
 A. Income elasticity leas than unity: When income increases quantity
demanded also increases but less than proportionately. In this case E < 1.

An increase in income from OY to OY, brings what an increase in quantity

demanded from OQ to OQ1, But the increase in quantity demanded is smaller
than the increase in income. Hence, income elasticity of demand is less than one.
3.Cross elasticity of Demand:
A change in the price of one commodity leads to a change in the quantity
demanded of another commodity. This is called a cross elasticity of demand. The
formula for cross elasticity of demand is:

Proportionate change in the quantity demand of commodity “X”

Cross elasticity = -----------------------------------------------------------------------
Proportionate change in the price of commodity “Y”
4. Advertising Elasticity:
It refers to increase in the sales revenue because of change in the advertising
expenditure. In other words, there is a direct relationship between the amount of many
spent on adverting and its impact on sales. Adverting elasticity is always positive.
Advertising elasticity =
Proportionate changes in unity demand for product X / Proportionate change in
advertisement cost.

The same is expressed as Eda = (Q2 – Q1) Q1/(A2-A1) A1

Where
Q1 is the quantity demanded before change

Q2is the quantity demanded after change

A1is the amount spent on advertising before change

A2 is the amount spent on advertising after change

 Factors influencing the elasticity of demand

Elasticity of demand depends on many factors.

Nature of commodity: Elasticity or in-elasticity of demand depends on the nature of
the commodity i.e. whether a commodity is a necessity, comfort or luxury, normally;
the demand for Necessaries like salt, rice etc is inelastic. On the other band, the
demand for comforts and luxuries is elastic.
Availability of substitutes: Elasticity of demand depends on availability or non-
availability of substitutes. In case of commodities, which have substitutes, demand is
elastic, but in case of commodities, which have no substitutes, demand is in elastic.
Variety of uses: If a commodity can be used for several purposes, than it will have
elastic demand. i.e. electricity. On the other hand, demanded is inelastic for
commodities, which can be put to only one use.
Postponement of demand: If the consumption of a commodity can be postponed,
than it will have elastic demand. On the contrary, if the demand for a commodity
cannot be postpones, than demand is in elastic. The demand for rice or medicine
cannot be postponed, while the demand for Cycle or umbrella can be postponed.

Amount of money spent: Elasticity of demand depends on the amount of money

spent on the commodity. If the consumer spends a smaller for example a consumer
spends a little amount on salt and matchboxes. Even when price of salt or
matchbox goes up, demanded will not fall. Therefore, demand is in case of
clothing a consumer spends a large proportion of his income and an increase in
price will reduce his demand for clothing. So the demand is elastic.
Time: Elasticity of demand varies with time. Generally, demand is inelastic
during short period and elastic during the long period. Demand is inelastic during
short period because the consumers do not have enough time to know about the
change is price. Even if they are aware of the price change, they may not
immediately switch over to a new commodity, as they are accustomed to the old
commodity.

Range of Prices: Range of prices exerts an important influence on elasticity of

demand. At a very high price, demand is inelastic because a slight fall in price
will not induce the people buy more. Similarly at a low price also demand is
inelastic. This is because at a low price all those who want to buy the commodity
would have bought it and a further fall in price will not increase the demand.
Therefore, elasticity is low at very him and very low prices.
 THEORY OF FIRM
The theory suggests that firms generate goods to a point where marginal cost
equals marginal revenue, and use factors of production such as Land, Labour,
Capital, enterprise, and organization to point where their marginal revenue
product is equal to the cost incurred in employing the factors. Behavior of the
firm in pursuit of profit maximization, analyzed in terms of what are inputs,
what production techniques are employed, what are the quantity produced, and
what prices it charges.
Profit-Maximizing Theory
The traditional objective of the business firm is profit-maximization. The theories
based on the objective of profit maximization are derived from the neo-classical
marginalist theory of the firm. Business is for profit, so the golden rule of business
is that, one who takes risks will reap profits. This is the most conventional thought,
and also the most widely accepted objective of a firm. Traditionally economists
assumed that generation of the largest amount of absolute profit over a period of
time is the single most important objective of a business organization.
Profit = Total Revenue-Total Cost
The Profit maximization Theory was based on the belief that and individual woulf
risk one’s risk and time for uncertain returns, only with the exception of generating
profits. Nobel Laureate Milton Friedman supported profit maximization theory on
the ground that its validity is tested by its ability to predict future business trends
and practices.
Baumol’s Theory of Sales Revenue Maximisation

Baumol Raised serious questions on the validity of profit maximization as an

objective of the firm. He stressed that in competitive markets, firms would rather
aim at maximizing revenue, through maximization of sales. According to him,
sales volumes, and not profit volumes, determine market leadership in
competition. Sales Maximization theory asserts that managers attempt to
maximize the firm’s total revenue, instead of profits
Modern Approach to Theory of Firm
Modern takes on the theory of the firm take such facts as low equity ownership by
many decision makers into account; some feel that chief executive officers (CEOs) of
publicly held companies are interested in profit maximization as well as in goals
based on sales maximization, public relations and market share.
Solely focus on Solely focusing on profit maximization comes with a level of risk in
regards to public perception and a loss of a sense of goodwill between the business
and other individuals or entities. Further risk exists when a firm focuses on a single
strategy within the marketplace. If a business relies on the sale of one particular good
for its overall success, and the associated product fails within the marketplace, this
can lead to a financial collapse of that particular company or department within a
company
 Supply Analysis
Supply represents how much the market can offer. The quantity supplied refers to
the amount of a good producers are willing to supply when receiving a certain
price. The supply of a good or service refers to the quantities of that good or
service that producers are prepared to offer for sale at a set of prices over a period
of time. According to Watson, Supply means a schedule of possible prices and
amounts that would be sold at each price. The supply is not the same concept as the
stock of something in existence, for example, the stock of commodity X in Delhi
means the total quantity of Commodity X in existence at a point of time; whereas,
the supply of commodity X in Delhi means the quantity actually being offered for
sale, in the market, over a specified period of time.
 Determinants of Supply
It is relevant to know the factors which determine supply of a product.
1. Price of the commodity: If the prices are high, the sellers are willing to supply
more goods to increase total revenue ultimately increasing their profit.
2. Cost of Production: Cost depends on the price of factors. Increase in factor cost
increases the cost of production, and reduces supply.
3. State of Technology: Use of advanced technology increases productivity of the
organization and increases its supply.
4. Number of Firms: With the increase in number of producers of a particular
product, the supply of the product in the market will increase. If entry is unrestricted,
new firms will continue to enter the market, thus increasing supply and degree of
competition. It results in decrease in supply of product by an individual firm.
5. Government Policies: Government policies related to taxes and subsidies on
certain products also have an effect on supply.
 Law of Supply
The law of supply states that a firm will produce and offer to sell greater quantity of a
product or service as the price of that product or services rises, other things being
equal. There is direct relationship between price and quantity supplied. In this
statement, change in price is the cause and change in supply is the effect. Thus, the
price rise leads to supply rise and not otherwise. It may be noted that at higher prices,
there is greater incentive to the producers or firms to produce and sell more. Other
things include cost of production, change of technology, price of related goods
(substitutes and complements), prices of inputs, level of competition and size of
industry, government policy, and non-economic factors.
Thus ‘Ceteris Paribus’;
a. With an increase in the price of the good, the producer is willing to offer more of
goods in the market for sale.
b. The quantity supplied must be related to the specified time interval over which it is
offered.