Managerial Economics 7

Unit 1: Introduction to Economic Analysis

Structure
Notes
1.1. Objectives
1.2. Introduction
1.3. Nature and scope of managerial economics and its relationship with other
disciplines
1.4. Scarcity and Efficiency
1.5. Basic Concepts and Principles of Micro-economic analysis
1.5.1. Marginalism
1.5.2. Opportunity Cost
1.5.3. Discounting Time Perspective
1.5.4. Risk and Uncertainty
1.6. Summary
1.7. Check Your Progress
1.8. Questions and Exercises
1.9. Further Readings

1.1 Objectives
The primary purpose of this chapter is to define and explain the scope of economics
and the methodology economists’ use in solving problems. A unique feature of this chapter
is that it explains the economic way of thinking and shows the student how to apply the
tools of economic thinking to everyday decisions. Graphs are used consistently in this
module, so the student will need a good knowledge of how a graph is constructed and
how to interpret its lines. It would be best to follow the examples in the appendix so that
the student has both the text and class notes to review. Stress that the concept of scarcity
is a key element in all economic analysis and a link to the rest of the course.

Key Terms:
Scarcity, resources, land, labor, capital, opportunity costs, marginalism, risk and
uncertainty, discounting time perspective

1.2 Introduction
Economics is essentially the study of logic, tools and techniques of making optimum
use of the available resources to achieve the ends. Economics thus provides analytical
tools and techniques that managers need to achieve the goals of the organization they
manage. Therefore, a working knowledge of economics, not necessarily a formal degree,
is essential for mangers. Managers are essentially practicing economists.
In performing his functions, a manager has to take a number of decisions in conformity
with the goals of the firm. Many business decisions are taken under the condition of
uncertainty and risk. Uncertainty and risk arise mainly due to uncertain behavior of the
market forces, changing business environment, emergence of complexity of the modern
business world and social and political, external influence on the domestic market and
social and political changes in the country. The complexity of the modern business world
adds complexity to business decision-making. However, the degree of uncertainty and
risk can be greatly reduced if market conditions are predicted with a high degree of reality.
The prediction of the future course of business environment alone is not sufficient. It is
important equally to take appropriate business decisions and to formulate a business
strategy in conformity with the goals of the firm.

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10 Managerial Economics

1.3. Nature and scope of managerial economics and its relationship

Notes with other disciplines
Taking appropriate business decisions requires a clear understanding of the technical
and environmental conditions under which business decisions are taken. Application
of economic theories to explain and analyze the technical conditions and the business
environment contributes a good deal to the rational decision-making process. Economic
theories have, therefore, gained a wide range of application in the analysis of practical
problems of business. With the growing complexity of business environment, the
usefulness of economic theory as a tool of analysis and its contribution to the process of
decision-making has been widely recognized.
Baumol has pointed out three main contributions of economic theory to business
economics. First, ‘one of the most important things which the economic (theories) can
contribute to the management science’ is building analytical models, which help to
recognize the structure of managerial problems, eliminate the minor details, which might
obstruct decision-making and help to concentrate on the main issue. Secondly, economic
theory contributes to the business analysis ‘a set of analytical methods’ which may not
be applied directly to specific business problems, but they do enhance the analytical
capabilities of the business analyst. Thirdly, economic theories offer clarity to the various
concepts used in business analysis, which enables the managers to avoid conceptual
pitfalls.

Scope of Managerial Economics

The problems in business decision-making and forward planning can be grouped into
four categories as follows:
 Problems of Resource Allocation: Source resources are to be used with utmost
efficiency to get the optimal results. These include production programming and
problems of transportation, etc.
 Inventory and Queuing Problems: Inventory problems involve decisions about
holding of optimal levels of stocks of raw materials and finished goods over a
period. These decisions have to be taken by considering demand and supply
conditions. Queuing problems involve decisions about installation of additional
machines or not hiring labor, against the cost of such machines or labor.
 Pricing Problems: Fixing prices for the products of the firm are important
decision-making problems. Pricing problems involve decisions regarding various
methods of pricing to be followed.
 Investment Problems: It is related of allocating resources over time. These
normally relate to: investing new plants, how much to invest, expansion programs
for the future, sources of funds, etc.
Managerial Economics (ME) seeks solutions to these problems. So, there is a wide
spectrum of topics that fall under ME and they are as follows:

1. Profit Analysis. 2. Cost Analysis

3. Production Possibility Chart 4. Pricing theory and policies
5. Demand Analysis 6. Market penetration studies
7. Economic Forecasting 8. Sales Forecasting
9. Marginal analysis 10. Break-even analysis
11. Competitive market studies 12. Anti-Trust issues
13. Plant location studies 14. Mergers and Acquisitions
15. Labor cost studies 16. Inventory problem
17. Investment analysis 18. Capital Budgeting
19. Cost of Capital 20. Government regulations
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Out of the above lists, there are some major areas, which are very much important for
management, they are as follows:
Notes
 Demand analysis and forecasting,
 Production and cost,
 Competition,
 Pricing and output, and
 Investment and capital budgeting.

1.4. Scarcity and Efficiency

Economics is the study of how economic agents or societies choose to use scarce
productive resources that have alternative uses to satisfy wants which are unlimited and
of varying degrees of importance. The main concern of economics is economic problem:
its identification, description, explanation and solution. The source of any economic
problem is scarcity. Scarcity of resources forces economic agents to choose among
alternatives. Therefore, economic problem can be said to be a problem of choice and
valuation of alternatives. The problem of choice arises because limited resources with
alternative uses are to be utilized to satisfy unlimited wants, which are of varying degrees
of importance. Scarcity is a relative concept. It can be define as excess demand, i.e.,
demand more than the supply. For example, unemployment is essentially the scarcity of
jobs. Inflation is essentially scarcity of goods.
The job of any efficient manager is of economic one. Decision-making is the main job of
management. Decision-making involves evaluating various alternatives and choosing the
best among them. For example, a marketing manager is to allocate his / her advertising
budget among various media in such a way so as to maximize the reach.

1.5. Basic Concepts and Principles of Micro-economic analysis

Managerial economics deals with firms, more especially with the environment in which
firms operate, the decisions they take and the effects of such decisions on themselves and
their stakeholders like customers, competitors, employees and the society in which they
operate. The key economic concepts and principles that constitute the broad framework
of managerial economics are explained here.

1.5.1. Marginalism
The root cause of all economic problems is scarcity. So, all should be careful about
the utilization of each and every additional unit of resources. In order to decide whether
to use an additional unit of resource you need to know the additional output expected
there from. Economists use the term marginal for such additional magnitude of output.
Marginalism concept will help to know the additional output expected from an additional
unit of resource. Therefore, marginal output of labour is the output produced by the last
unit of labour.

1.5.2. Opportunity Cost

Economic decision is choosing the best alternative among available alternatives.
Before choosing best alternative you rank them all based on their priority and probable
return. This choice implies sacrificing the other alternatives. The cost of this choice can
be evaluated in terms of the sacrificed alternatives. If the best alternative was not chosen
then you could have chosen the second best alternative. So, the cost of this particular
best choice is the benefit of the next best alternative foregone. This is called Opportunity
Cost.

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1.5.3. Discounting Time Perspective

Notes Discounting principle refers to time value of money, i.e., the fact that the value of
money depreciates with time. The core discounting principle is that a rupee in hand today
is worth more than a rupee received tomorrow. One rationale of discounting is uncertainty
about tomorrow, i.e., future. Even if there is no uncertainty, it is necessary to discount
future rupee to make it equivalent to current day rupee. In business situations, most of the
decisions relate to outflow and inflow of money and resources that take place at different
point of time. Most outflows normally occur in the current period, whereas inflows occur
only in future, therefore, in order to take the right decision it is necessary to “discount”
future inflows to their present value level. The simple formula for discounting is:
PVF = 1 / (1+rn)
Where PVF = present value of fund, n= period (year, etc.) and r = rate of discount.

1.5.4. Risk and Uncertainty

The uncertainty is due to unpredictable changes in the business cycle, structure of
the economy and government policies. This means that the management must assume
the risk of making decisions for their organizations in uncertain and unknown economic
conditions in the future.
Firms may be uncertain about production, market-prices, strategies of rivals, etc.
Under uncertain situation, the consequences of an action are not known immediately
for certain. Economic theory generally assumes that the firm has perfect knowledge of
its costs and demand relationships and its environment. Uncertainty is not allowed to
affect the decisions. Uncertainty arises because producers simply cannot foresee the
dynamic changes in the economy and hence, cost and revenue data of their firms with
reasonable accuracy. Dynamic changes are external to the firm and they are beyond the
control of the firm. The result is that the risk from unexpected changes in a firm’s cost and
revenue cannot be estimated and therefore the risk from such changes cannot be insured.
The managerial economists have tried to take account of uncertainty with the help of
subjective probability. The probabilistic treatment of uncertainty requires formulation of
definite subjective expectations about cost, revenue and the environment.

1.6. Summary
The managerial economics can be viewed as an application of that part of
microeconomics that focuses on such topics as risk, demand, production, cost, pricing and
market structure. Understanding these principles will help to develop a rational decision-
making perspective and will sharpen the analytical framework that the managers must
bring to bear on managerial decisions.

Check Your Progress

1. Uncertainty and risk arise mainly due to
(a) Uncertain behavior of the market forces,
(b) Changing business environment,
(c) Emergence of complexity of the modern business world and social and political,
external influence on the domestic market and social and political changes in the
country,
(d) All above
2. Source resources are to be used with utmost efficiency to get
(a) The optimal results, (b) The Sub-optimal results,
(c) The Normal results, (d) All the above.

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Managerial Economics 11

3. The root cause of all economic problems is

(a) Over-population, (b) Scarcity, Notes
(c) Capital (d) Poor management
4. Discounting principle refers to
(a) Time value of interest, (b) Time value of money,
(c) Time value of investment, (d) Time value of capital.

Questions and Exercises

1.1. “Managerial economics is an integration of economic theory, decision science and
business management.” Comment.
1.2. “Economics is a science of choice when faced with unlimited ends and scarce
resources having alternative uses.” Comment.
1.3. “Managerial economics uses the theories of economics and the methodologies of the
decision sciences for managerial decision-making.” Elaborate.
1.4. Discuss the salient features and significance of managerial economics.
1.5. Highlight the role and responsibilities of a business / managerial economist.
1.6. Write short notes on the followings:
1.6.1. The Nature of Managerial Economics.
1.6.2. Functions of Managerial Economist.
1.6.3. Decision Making under Uncertainty.
1.6.4. Opportunity Cost.
1.6.5. Marginal Analysis.
1.6.6. Discounting Principles

Fundamental Questions
1. What is economics?
2. What are opportunity costs?
3. How are specialization and opportunity costs related?
4. What is Marginalism?
5. What is Risk and Uncertainty?
6. What is Discounting Time Perspective?

Skill Development
i) Prepare a mini case study of a business expansion strategy of a Laptop dealer in
your area.
ii) Prepare a hypothetical case study for an automobile firm in India to deal with
would be problem of launching of small cars like NANO.

Further Readings
 Hirschey, Economics for Managers, Cengage Learning
 Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
 Froeb, Managerial Economics: A Problem Solving Approach, Cengage Learning
 Mankiw, Economics: Principles and Applications, Cengage Learning

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 Gupta, G.S. 2006, Managerial Economics, 2nd Edition,Tata McGraw Hill

Notes  Peterson, H.C and Lewis, W.C. 2005, Managerial Economics, 4th Edition, Prentice
Hall of India
 R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics
Macmillan.
 Varshney, R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
 Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and
Review, 6th Edition, Tata McGraw Hill.

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