CH 05

Part I: Concepts And Techniques
Ch-5 Basic Tools and Techniques of Economic Analysis
Chapter
5
Basic Tools and
Techniques of Economic Analysis
Copyright© Manab Adhikar
5-1 BUSINESS ECONOMICS (2nd Edition) Excel Books

Introduction
Let us now move from ‘concepts’ to ‘techniques’. It should be
kept in mind that concepts and techniques are not mutually
exclusive. The use of techniques is geared towards measurement
and optimisation of economic decision variable. In what follows,
our objective is to:
• Help you understand the basic mathematics, which is very

useful in business economics;
• Introduce you to the formal concept of ‘optimisation’ in

decision making context;
• Suggest the use of calculus in measuring economic

magnitudes and in optimising economic decision variables;
and
•
5-2
Make you aware of other tools and techniques like model-
BUSINESS ECONOMICS (2nd Edition) Excel Books
Basic Mathematics
The first concept is that of a set. A set is defined to be a
collection of distinct and well defined objects. In fact, a set can
be defined in two ways — either by enumeration of its members
or by specifying a criterion for membership. An example of the
first would be the set of numbers 8,9,10 written as (8,9,10); or the
set of alphabets, c,d,e written as (c,d,e). Sometimes it is difficult
to define a set by listing its members.
In business economics, we will be concerned with the choice
executed by a business firm, often the need arises for specifying
the opportunity cost of the decision-maker, i.e., the set of
alternative actions which are feasible.
In business economics, we deal with variables, like consumption,
demand, supply, income, investment, wages, profits, etc. Cont…. A
variable is a thing which varies, which can take a set of possible
5-3 BUSINESS ECONOMICS Excel Books
a given (2problem.
Edition) A constant is a quantity,
nd
values within which
A function can be represented by means of a table or by means of

a graph. A graph is a geometric representation of the relationship
embodied in the function. Suppose, the specific form of the
demand function is D=10-0.5P where 10 and 0.5 are constants. In
Table
a table form, the function can be5.2A
represented as follows:
P 1 2 3 4 5
D 9.5 9 8.5 8 7.5
Quantity Demanded (D)
10
D =10 – 0.5 P
Cont….
0 Price (P) 20 Copyright© Manab Adhikar

Graphs of functions can take different forms, depending on the

form of the functions. Three functions frequently encountered in
business economics involving a single independent variable are
given below:
O B
Linear Q=a–bP
a=OA, b=OA/OB
Cont….

A
A
O O
Quadratic Quadratic
Q=a–bP–cP2 Q=a+bP–cP2
a=OA, c > O a = OA
Cont….

O
Cubic
Q=a+bP+cP2+dP3
a = OA

Calculus
The marginal concept in Economic analysis is easily amenable to
the method of calculus. Suppose Y=Y(X). Then by way of marginal
concept, we try to find out what is the impact on Y because of an
additional change in X. In calculus notation, it reads . Some of the
standard rules of differentiation in calculus are:
y
a) Basic rule : Yx= a xn y
= na x n-1
x
y u v
b) Addition rule : Y
x= u(x)
x +
x v(x)
= +
 u 
 u ´v v (x)
c) Product rule : Y
y
=vu(x)
 x x
x 2
u(x) v
v (x)
d) Quotient rule : Y=
= v (x) - u (x)
y u u
e) Chain rule : Yx = yx[u (x)]
x
y
= x
1
f) Logarithm rule :x x Y = loge x
=
y Copyright© Manab Adhikar
g) Exponential rule :x Y = ex
= ex
Optimisation
The idea of optimisation is present in any quantitative decision
making. For instance, a consumer’s choice of consumption
bundle, a firm’s production decision, a planner’s choice of
resource allocation in the economy and so on are the examples
where optimisation decision is involved. Optimisation means the
act of choosing the best alternative out of whatever alternatives
are available. It helps in making decisions (i.e., choice among
alternatives). All optimisation problems consist of three
elements.
1. The decision variables: These are variables where optimal
values have to be determined. For example, production
manager wants to know at what level to set output in order to
achieve maximum profits or maximum sales revenue. Here
output is the decision variable or choice variable.
2. The objective function: The objective function is a
mathematical relationship between the choice variables and
some variables whose values an economicCont….
agent wishes
Copyright© to
Manab Adhikar
maximise or minimise. Thus, the objective function could relate:

5-9 BUSINESS ECONOMICS (2
nd
Edition) Excel Books
3. The feasible set: An essential part of any optimisation

problem is specification of exactly what alternatives are
available to the decision maker. The available set of
alternatives is called the feasible set.

Unconstrained Optimisation Technique

The calculus technique is extensively used in solving
optimisation problems. In the context of decision making
“optimisation” may mean maximisation or minimisation, either of
them may be with constraints or without constraints.
Unconstrained Optimisation
For unconstrained optimisation problem involving single
independent
Order variables,
Conditions certain ‘conditions’ need to
Optimisation be satisfied
(Unconstrained)
which are shown below:
First order Necessary Maximisation
Minimisation
Conditions ay/ax = o ay/ax = o
Second order Sufficient a2y/ax2 < o a2y/ax2 > o
Conditions
We are assuming that y = y(x)

Constrained Optimisation Technique

The techniques which are used to analyse such a problem are
based on the techniques used for unconstrained problems. We
convert the constrained problem into an unconstrained one and
solve the latter. This is done with the help of a technique called
Lagrange Multiplier Technique. In this method we combine the
objective function and the constraint in one expression, which is
called the Lagrange expression. In doing so the constrained
maximisation or minimisation problems are reduced to one of
unconstrained maximisation or minimisation problem.
Let us explain the technique with the help of an example.
Maximise y = x + 8y + 20
2
Cont….
Subject to x < 2 Copyright© Manab Adhikar

We combine the two to get the Lagrangian expression.
L = [-(x – 4)2 + 36] +f (x – 2).
Involving the expression L we take the objective function and add

the product of l (which is called the Lagrangian Multiplier,
L L
pronounced as Lamda) and the constraint function x –2 =x 0. Now

L is a function of x and l. We find out and set them to

zero.
L
x
L = -2(x – 4) + l = 0……………………………………. (i)
x
= (x – 2) = 0………………………………………….. (ii)
Cont….

40
36
35
32
30
25
20
15
10
Z X
-2 0 2 4 6 8 10

Input-Output Model
Economists are fond of using models. A model is a structure of
relationship stated in a form, functional or tabular. For example,
we talk of input-output model.
Input-Output technique is another very popular technique of

economic analysis, though it is not an optimisation one. This
technique is useful in the context of macro level planning and
projection. At the micro level of a corporate unit, Input-Output
model lies at the root of end-use method of demand forecasting.
Matrix is basic for understanding the rationale and use of Input-

Output models. Such a model essentially states the nature of
technological relationship, which exists between sectors. Cont….
Let BUSINESS
5-15 us explain the Input-Output
ECONOMICS (2nd Edition) model with the help ofBooks
Excel the
Output
1 2 3 Households Government Capital Rest Total
of the out
world put
Input
1 x 11 x12 x13 Ch1 Cg11 K (E-M 1) x1
2x 21
x22 x23 Ch2 Cg22 K (E-M 2) x2
3x 31
x32 x33 Ch3 Cg33 K (E-M 3) x3
Households Y1 Y2 Y3 Y
Government NIT 1 NIT2 NIT3 NIT
Corporate D1 D2 D3 D
Rest of the
world
Total Input x1 x2 x3 CH CG I E-M

Linear Programming
linear programming has three constituents.
1. Objective function:
2. Constraints
3. Non-negativity constraints
There are many methods to solve the linear programming
problems but we would employ only one method namely,
graphical method to solve a problem. Again since we can have
maximisation as well as minimisation linear programming
problems we will consider the maximisation case only.
Example: A furniture manufacturing company makes two types of
furniture, chairs and tables. The contribution for each product as
computed by the company’s accounting department is Rs 10 per
chair and Rs 15 per table. Both these products are processed on
three machines, say A, B and C. The time required by each Cont….
product and total time available (per week) on each machine is
as follows:
Hours required
Machine Chair Table Available
hours
per week
A 3 3 36
B 5 2 50
C 2 6 60

Game Theory
It is a purely mathematical device, which has been developed to
explain economic behaviour of “players” in a given market
environment. The game theory can be treated as an optimisation
technique guiding decisions – choice made by individuals in
situations in which the consequences of such choices of other
individuals. In other words, when there is inter-dependence in
decision making, optimal decision may be arrived at through the
use of game theory. For example, in a situation of duopoly (when
there are two sellers), when two sellers confront each other for a
given market share, the game theoretic techniques may be used
to locate a stable equilibrium solution.
There are various types of games – two person zero sum, two
person constant sum. There can also be n-person game,
applicable in oligopoly situation where there are 5 to 7 sellers.

5-19 BUSINESS ECONOMICS (2
nd
Edition) Excel Books
Models and Cases

Models
• Iconic Models
These are pictorial or visual representations like drawings,
design, prototype, etc., which provide information to
management.
• Analogue Models
Such models present a set of properties of the data in a form
which is easily amenable to analysis, e.g., a flow chart,
funds flow statement, statistical distributions such as
binomial, poisson, normal, etc.
• Mathematical Models
In these models, relationships are expressed in mathematical
symbols and equations. Such models are extensively used in
Cont….
economic analysis. These may be further classified as under:
i. Economic Models
Cases
The case method is a pedagogical technique. In business
economics, the case method is useful to the extent it stimulates
a real world business situation.
There is no definite procedure in analysing a case, but normally
the case analyst follows an ordered sequence of the following
step:
1. Identify the key issue; keep away the trivial issues.
2. Establish the nature of the issue, the problem of choice by
examining the available data (facts and figures).
3. Examine the information gap and make necessary
assumptions to bridge that gap.
4. Analyse the facts assumed information.
5. Work out the range of alternative solutions and the implied
consequences.
6. Recommend a particular solution out of the given set of
alternatives; this is what can be termed as a “decision”.
5-21 Excel Books
7. BUSINESS
Use theECONOMICS (2nd Edition)
“decision” as a subject for discussion and
Statistical Tools and Techniques

Frequency Distributions
Some definitions associated with a frequency distribution are:
Class Limits: The boundary values of a class are called the class
limits. The smaller of the two class limits is known as the lower
limit and the greater value is known as upper limit. In the class
20-40, 20 the lower limit and 40 is the upper limit.
Class Interval: The difference of the upper and lower limits is
called the class interval or width of the class.
Cumulative Frequency: It is the total of the observations
(frequencies) upto and including the observations of that class,
e.g., cumulative frequency of the class 40-60 is 34.
Cont….

Measures of Central Tendency
These are statistical constants which give us an idea about the

concentration of the values in the central part of the distribution.
A central value is the one around which other values of a
distribution revolve.
The various measures of central tendency are:
1. Arithmetic Means ()
2. Median (Md)
3. Mode (Mo)
4. Geometric Mean (G.M)

Cont….
5. Harmonic Mean (H.M) Copyright© Manab Adhikar

Combined Mean and Standard Deviation

Combined Mean
If we have two distributions with number of observations equal to
N1 and N2 and Arithmetic means as X1 and X2 respectively then
the combined mean of both the distributions together is given by:
X n  X 2 n2
X= 1 1
n 1  n2
Combined Standard Deviation
If we have two distributions with number of observations equal to
N1, N2 Arithmetic means as X1, X2 and standard deviations as s1
and s2 respectively then the combined standard deviation is
computed as 2 2
n1 σ 1 + n2 σ 2 + n1 d1 + n2 d2
2 2
σ=
n 1 + n2
X X1
Cont….
Where dX
1 = X 2
- Copyright© Manab Adhikar
And d2 = -
Measures of Skewness
Measurement of skewness gives us a measure of departure from
symmetry. This departure from symmetry or lack of symmetry is
called skewness. The following diagrams would clarify the
meaning of skewness.
Med.
X= Med. = Mode Mode X

(b) Positively Skewed Distribution
(a) Symmetrical Distribution
Med.
X Mode
(c) Negatively Skewed Distribution
Cont….

Measures of Kurtosis
Kurtosis gives us idea about the flatness or peaked ness of a
distribution curve.
B
The diagram below illustrates the scope of three different curves:
Kurtosis Leptokurtic
A Mesokurtic
C Platykurtic
Cont….
(A) Measokurtic (B) Leptokurtic (C) Platykurtic Copyright© Manab Adhikar

Probability
A few concepts need to be understood before the theory of

Probability is introduced. Some of the important concepts are:
1. Random Experiments and Events
2. Exhaustive Events
3. Favourable Events
4. Mutually Exclusive Events
5. Equally Likely Events
Cont….

Definition of Probability
If there are ‘n’ exhaustive, mutually exclusive and equally likely

events out of which ‘m’ are favourable to the happening of an
event A, then the probability of the happening of A, denoted by
P(A), is defined as
Favourable number of cases m
P (A) = 
Exhaustive number of cases n
Compound Events
The simultaneous occurrence of two or more events is called a

compound event. For example, drawing 5 white balls and then 3
black balls from an urn containing 10 white balls and 7 black
Cont….
balls is a compound event. Copyright© Manab Adhikar

Sampling
Sampling and tests of significance are very important tools in
business economics. In fact one cannot do any meaningful
marketing research without the requisite knowledge of sampling
techniques.
1. Random Sampling
2. Simple Sampling
3. Large and small sample
4. Hypothesis
5. Null Hypothesis
6. Parameters and Statistics
7. Level of significance

A Return to Game Theory

Decision making has become more complex in today’s
competitive business world. The decision maker has to guess the
activities of his competitor and then adopt a policy to ‘counter’
its market effects. Further, while adopting such a policy he has
again to guess what possible rival actions his competitor can
take in order to counter his policy. Such situations of “business
conflict” occur in almost every walk of life.
The various characteristics of a competitive game are:
i. The number of players (competitors) is finite,
ii. There is a conflict of interest between the players,
iii. Each player has available to him a finite number of possible
courses of action, referred to as strategies,
iv. Rules governing the choice of actions are known to each
player. Each player chooses one of his courses of action. These
choices are assumed to be made simultaneously, so that no
player knows his opponent’s choice until he has decided
his own course of action, Cont….
v. The outcome of the ndgame is affected by the choices made by

5-30 BUSINESS ECONOMICS (2 Edition) Excel Books
Zero-sum and Non-Zero-sum Games
Competitive games are classified according to the number of

players involved, i.e., as a two-person game, three-person game,
etc. Another important distinction is between Zero-sum games
and Non-zero sum games. If the players make payments only to
each other, i.e., the loss of one is the gain of other and nothing
comes from outside, the competitive game is said to be Zero-
sum.
Two-Person Zero-sum Games
We would be confining over selves only to Two-person Zero-sum

game. By definition, Zero-sum games with only two players or
competitors are called Two-person Zero-sum or Rectangular
Cont….
games.
The Maximin-Minimax Criterion

Let us try to find a solution of the optimal strategies by the two
players, by employing maximin-minimax criterion. Suppose that
both the players are conservative, i.e., while employing his
strategy R1, player R believes that his opponent knows that he is
going to employ R1 and similarly player C believes so about
player R while employing his moves.
The following are some extensions of the games which can be
considered but it is beyond the scope of this book.
a) N-person games
b) Non-zero-sum-game
c) Co-operative games
d) Infinite games Copyright© Manab Adhikar

Matrices and Their Applications

A matrix is a rectangular array of numbers, usually represented
by enclosing the array by brackets. The numbers of rows and
columns are called the dimensions or order of a matrix.
• Vectors
• Elementary Algebra of Matrices
• Scalar Multiplication
• Multiplication of Matrices
Cont….

Some Types of Matrices

• Zero or Null Matrix
• Diagonal Matrix
• Upper and Lower Triangular Matrices
• The Identity Matrix
• The Transpose of a Matrix
• Symmetric Matrices
• Determinant of a Matrix
• Adjoint Matrix
• Linear Dependence
• The Rank of a Matrix
• Inverse of Matrix
• Application of Matrices of Linear Systems
• Applications and Advantages of Matrix Algebra

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Part I: Concepts And Techniques

Ch-5 Basic Tools and Techniques of Economic Analysis

Copyright© Manab Adhikar

5-1 BUSINESS ECONOMICS (2nd Edition) Excel Books

• Help you understand the basic mathematics, which is very

• Introduce you to the formal concept of ‘optimisation’ in

• Suggest the use of calculus in measuring economic

A function can be represented by means of a table or by means of

5-4 BUSINESS ECONOMICS (2nd Edition) Excel Books

Graphs of functions can take different forms, depending on the

5-5 BUSINESS ECONOMICS (2nd Edition) Excel Books

5-6 BUSINESS ECONOMICS (2nd Edition) Excel Books

Copyright© Manab Adhikar

5-7 BUSINESS ECONOMICS (2nd Edition) Excel Books

maximise or minimise. Thus, the objective function could relate:

3. The feasible set: An essential part of any optimisation

Copyright© Manab Adhikar

5-10 BUSINESS ECONOMICS (2nd Edition) Excel Books

Unconstrained Optimisation Technique

5-11 BUSINESS ECONOMICS (2nd Edition) Excel Books

Constrained Optimisation Technique

Let us explain the technique with the help of an example.

5-12 BUSINESS ECONOMICS (2nd Edition) Excel Books

We combine the two to get the Lagrangian expression.

L = [-(x – 4)2 + 36] +f (x – 2).

Involving the expression L we take the objective function and add

L is a function of x and l. We find out and set them to

5-13 BUSINESS ECONOMICS (2nd Edition) Excel Books

Copyright© Manab Adhikar

5-14 BUSINESS ECONOMICS (2nd Edition) Excel Books

Input-Output technique is another very popular technique of

Matrix is basic for understanding the rationale and use of Input-

1 x 11 x12 x13 Ch1 Cg11 K (E-M 1) x1

Government NIT 1 NIT2 NIT3 NIT

Total Input x1 x2 x3 CH CG I E-M

Copyright© Manab Adhikar

5-16 BUSINESS ECONOMICS (2nd Edition) Excel Books

Copyright© Manab Adhikar

5-18 BUSINESS ECONOMICS (2nd Edition) Excel Books

applicable in oligopoly situation where there are 5 to 7 sellers.

Models and Cases

Statistical Tools and Techniques

5-22 BUSINESS ECONOMICS (2nd Edition) Excel Books

Measures of Central Tendency

These are statistical constants which give us an idea about the

The various measures of central tendency are:

4. Geometric Mean (G.M)

5-23 BUSINESS ECONOMICS (2nd Edition) Excel Books

Combined Mean and Standard Deviation

X= Med. = Mode Mode X

5-25 BUSINESS ECONOMICS (2nd Edition) Excel Books

(A) Measokurtic (B) Leptokurtic (C) Platykurtic Copyright© Manab Adhikar

5-26 BUSINESS ECONOMICS (2nd Edition) Excel Books

A few concepts need to be understood before the theory of

1. Random Experiments and Events

4. Mutually Exclusive Events

5. Equally Likely Events

5-27 BUSINESS ECONOMICS (2nd Edition) Excel Books

If there are ‘n’ exhaustive, mutually exclusive and equally likely