UNIT 2 THE FIRM: STAKEHOLDERS, .

OBJECTIVES AND DECISION ISSUES

Objectives
After studying this unit, you should be able to :
understand the rationale for existence of firms;
understand the concept of economic profit and accounting profit;
appreciate the use of opportunity cost;
differentiate between various objectives of the firm.

Structure
2.1 Introduction
2.2 Objective of the Firm
2.3 Value Maximisation
2.4 Alternative Objectives of the Firms
2.5 Goals of Real World Firms
2.6 Firm’s Constraints
2.7 Basic Factors of Decision-Making: The Incremental Concept
2.8 The Equi-Marginal Principle
2.9 The Discounting Principle
2.10 The Opportunity Cost Principle
2.11 The Invisible Hand
2.12 Summary
2.13 Self-Assessment Questions
2.14 Further Readings

2.1 INTRODUCTION
The firm is an organisation that produces a good or service for sale and it plays a
central role in theory and practice of Managerial Economics. In contrast to non-
profit institutions like the ‘Ford Foundation’, most firms attempt to make a profit.
There are thousands of firms in India producing large amount of goods and
services; the rest are produced by the government and non-profit institutions. It is
obvious that a lot of activities of the Indian economy revolve around firms.

One of the crucial determinants of a firm’s behaviour is the state of technology.

Technology imposes a limit on how much a firm can produce. It is the sum total of
society’s pool of knowledge concerning the industrial and agricultural arts.
Production is any activity that transforms inputs into output and is applicable not
only to the production of goods like steel and automobiles, but also to production of
services like banking and insurance.

The firm changes hired inputs into saleable output. An input is defined as anything
that the firm uses in its production process. Most firms require a wide array of
inputs. For example, some of the inputs used by major steel firms like SAIL or
TISCO are iron ore, coal, oxygen, skilled labour of various types, the services of
blast furnaces, electric furnaces, and rolling mills as well as the services of the
people managing the companies. To give another example, the inputs in production
and sale of “chaat” by a street vendor are all the ingredients that go into making of
the “chaat”, i.e. the stove, the “carrier”, and the services of the vendor. The inputs 1
Introduction
or thetofactors
Managerial
of production
are divisible into two broad categories - human The Firm: Stakeholders,
Economics Objectives and Decision
resources and capital resources. Labour resource and entrepreneurial resource are Issues
the two human resource inputs while land, man-made capital forests, rivers, etc. are
the two capital resources. Thus the four major factors of production (FOP) are
land, man made capital, labour, and entrepreneur (organisation) while the
remuneration they get is rent, interest (capital rental), wage, and profit, respectively.

The function of the firm, thus, is to purchase resources or inputs of labour services,
capital and raw materials in order to convert them into goods and services for sale.
There is a circular flow of economic activity between individuals and firms as they
are highly interdependent. Labour has no value in the market unless there is a firm
willing to pay for it. In the same way, firms cannot rationalise production unless
some consumer is willing to buy their products. However, there is some incentive
for each. Firms earn profits inturn satisfying the consumption demand of individuals
and resource owners get wage, rent and interest payment. In the process of
supplying the goods and services that consumers demand, firms provide
employment to workers and also pay taxes that government uses to provide service
(education, defense) that firms could not provide at all or as efficiently.

Essentially a firm exists because the total cost of production of output is lower than
if the firm did not exist. There are several reasons for lower costs. Firstly, long-
term contract with labour saves the transaction costs because no new contract has
to be negotiated every time a labour is to be hired or given new assignment.
Secondly, there are government regulations like price-control and sales taxes also
saved by having the transaction within the firm. Recall that sales tax is levied for
transaction between firms and not within firms. When transactions take place
within a firm they may be cheaper and hence such savings decrease the total cost
of production of an output. In other words, the existence of firms could be
explained by the fact that it saves transaction costs.

However, the size of the firm has to be limited because as the firms grow larger, a
point is reached where the cost of internal transaction becomes equal to or greater
than the cost of transaction between firms. When such a stage is reached, it puts a
limit to the size of the firm. Further, the cost of supplying additional services like
legal, medical etc. within the firm exceeds the cost of purchasing these services
from other firms; as such services may be required occasionally.

Let us consider the size of different kinds of firms around us and try to understand
the reasons for such differences. Why are service firms generally smaller than
capital-intensive firms like SAIL, Maruti Udyog, and ONGC etc? What is the
reason that a number of firms are choosing the BPO route? A part of the
explanation must lie in the fact that it is cheaper to outsource than to absorb that
activity within the firm. Consider a firm that needs to occasionally use legal service.
Under what conditions will it choose to hire a full time lawyer and take her on its
rolls and under what conditions will the firm outsource the legal activity or hire legal
services on a case-by-case basis. Naturally, the answer depends upon the
frequency of use for legal services. The transaction cost framework demonstrates
that the firm will contract out if the cost of such an arrangement is lower and will
prefer in-house legal staff when the opposite is true.

Firms are classified into different categories as follows:

a) Private sector firms.
b) Public sector firms.
c) Joint sector firms.
d) Non-profit firms.

2
 Figure 2.1: Interdependence of Consumers and Firms

Product
Goods and Services Goods and Services
Market

Consumers Firms

Economic Economic
Resources Resources

Income Factor Factor Payment

Market

Firms can also be classified on the basis of number of owners as:

a) Proprietorship.
b) Partnership.
c) Corporations.

Some firms mentioned below are different from above. They may provide service
to a group of clients for example, patients or to a group of its members only.
a) Universities.
b) Public Libraries.
c) Hospitals.
d) Museums.
e) Churches.
f) Voluntary Organisations.
g) Cooperatives.
h) Unions.
i) Professional Societies, etc.

The concept of a firm plays a central role in the theory and practice of managerial
economics. It is, therefore, valuable to discuss the objectives of a firm.

2.2 OBJECTIVE OF THE FIRM

The traditional objective of the firm has been profit maximisation. It is still regarded
as the most common and theoretically the most plausible objective of business
firms. We define profits as revenues less costs. But the definition of cost is quite
different for the economist than for an accountant. Consider an independent
businessperson who has an MBA degree and is considering investing Rs.1 lakh in a
retail store that she would manage. There are no other employees. The projected
income statement for the year as prepared by an accountant is as shown below:
3
Introduction to Managerial The Firm: Stakeholders,
EconomicsSales: Rs. 90,000 Objectives and Decision
Less: Cost of Goods sold Rs. 40,000 Issues
Gross Profit : Rs. 50,000
Less: Advertising Rs. 10,000
Depreciation Rs. 10,000
Utilities
Property Tax
Misc.
Rs. 3,000
Rs. 2,000
Rs. 5,000
6 = Rs. 30,000
Net Accounting Profit Rs. 20,000

This accounting or business profit is what is reported in publications and in the

quarterly and annual financial reports of businesses.

The economist recognises other costs, defined as implicit costs. These costs are not
reflected in cash outlays by the firm, but are the costs associated with foregone
opportunities. Such implicit costs are not included in the accounting statements but
must be included in any rational decision making framework. There are two major
implicit costs in this example. First, the owner has Rs.1 lakh invested in the
business. Suppose the best alternative use for the money is a bank account paying a
10 per cent interest rate. This risk less investment would return Rs.10,000 annually.
Thus, Rs.10,000 should be considered as the implicit or opportunity cost of having
Rs.1 lakh invested in the retail store.

Let us consider the second implicit cost, which includes the manager’s time and
talent. The annual wage return on an MBA degree may be taken as Rs.35,000 per
year. This is the implicit cost of managing this business rather than working for
someone else. Thus, the income statement should be amended in the following way
in order to determine the economic profit:

Sales : Rs. 90,000

Less: Cost of goods sold Rs. 40,000
Gross Profit : Rs. 50,000
Less Explicit Cost:
Advertising Rs. 10,000
Depreciation Rs. 10,000
Utilities
Property Tax
Misc.
Rs. 3,000
Rs. 2,000
Rs. 5,000
6 = Rs. 30,000

Accounting Profit Rs. 20,000

Less : Implicit Costs :
Return on Rs.1 lakh
of capital Rs. 10,000
Foreign wages Rs. 35,000 }= Rs.45,000
Net “Economic Profit” Rs. 25,000

Looking at this broader perspective, the business is projected to lose Rs.25,000 in

the first year. Rs. 20,000 accounting profit disappears when all relevant costs are
included. Another way of looking at the problem is to assume that Rs.1 lakh had to
be borrowed at, say, 10 per cent interest and an MBA graduate hired at Rs.35,000
per year to run the store. In this case, the implicit costs become explicit and the
accounting made explicit. Obviously, with the financial information reported in this
way, an entirely different decision might be made on whether to start this business
or not.

Thus, we can say that economic profit equals the revenue of the firm minus its
explicit costs and implicit costs. To arrive at the cost incurred by a firm, a value
4
must be put to all the inputs used by the firm. Money outlays are only a part of the
costs. As stated above, economists also define opportunity cost. Since the
resources are limited, and have alternative uses, you must sacrifice the production
of a good or service in order to commit the resource to its present use. For
example, if by being the owner manager of your firm, you sacrifice a job that offers
you Rs. 2,00,000 per annum, then two lakhs is your opportunity cost of managing
the firm. Similarly, if he was not playing cricket, Sachin Tendulkar, could have
earned a living (perhaps, not such a good one!) by being a cricket commentator.
Sachin’s opportunity cost of playing cricket is the amount he could have earned
being a television commentator.

The assignment of monetary values to physical inputs is easy in some cases and
difficult in others. All economic costing is governed by the principle of opportunity
cost. If the firm maximises profits, it must evaluate its costs according to the
opportunity cost principle. Assigning costs is straightforward when the firm buys an
input on a competitive market. Suppose the firm spends Rs. 20,000 on buying
electricity. For its factory, it has sacrificed claims to whatever else Rs 20,000 can
buy and thus the purchase price is a reasonable measure of the opportunity cost of
using that electricity. The situation is the same for hired factors of production.
However, a cost must be assigned to factors of production that the firm neither
purchases, nor hires because it already owns them. The cost of using these inputs
is implicit costs and has to be imputed. Implicit costs arise because the alternative
(opportunity) cost doctrine must be applied to be firm. The profit calculated after
including implicit as well as explicit costs in total cost is called economic profit.

Profit plays two primary roles in the free-market system. First, it acts as a signal to
producers to increase or decrease the rate of output, or to enter or leave an
industry. Second, profit is a reward for entrepreneurial activity, including risk taking
and innovation. In a competitive industry, economic profits tend to be transitory.
The achievement of high profits by a firm usually results in other firms increasing
their output of that product, thus reducing price and profit. Firms that have
monopoly power may be able to earn above-normal profits over a longer period;
such profit does not play a socially useful role in the economy.

Although, profit maximisation is a dominant objective of the firm, other important

objectives of the firm, other than profit maximisation that we will discuss in this unit
are:
1. Maximisation of sales revenue.
2. Maximisation of firm’s growth rate
3. Maximisation of manager’s own utility or satisfaction
4. Making a satisfactory rate of profit.
5. Long-run survival of the firm
6. Entry-prevention and risk avoidance.
Activity 3

a) “Among the various objectives of a modern firm, profit maximsation is the most
important”. Comment.
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
.....................................................................................................................
b) Outline the circular flow of economic activity between individuals and firms.
.....................................................................................................................
5
Introduction.....................................................................................................................
to Managerial The Firm: Stakeholders,
Economics Objectives and Decision
..................................................................................................................... Issues

.....................................................................................................................

c) (i) .................................. profit is a cost of doing business and is the amount by

which .................................. exceeds .................................. profit.
(ii) When a firm earns just a normal rate of return, ...........................................
equals total economic cost and .................................. profit is zero.

d) A firm collects Rs. 1.75 lakhs in revenue and spends Rs. 80 thousands on raw
materials in a year. The owners of the firm have provided Rs. 5 lakhs of their
own money to the firm instead of investing the money and earning a high rate of
interest.
(i) The firm earns economic profit of ........................................... . The firms
normal profit is ...................................................................................... .
(ii) The firm’s accounting profit is ................................................................ .
(iii) If the firm’s costs stay the same but its revenue falls to ..................................,
only a normal profit is earned.

2.3 VALUE MAXIMISATION

Most firms have sidelined short-term profit as their objective. Firms are often found
to sacrifice their short-term profit for increasing the future long-term profit. Thus,
the theory states that the objective of a firm is to maximise wealth or value of the
firm. For example, firms undertake research and development expenditure,
expenditure on new capital equipment or major marketing programmes which
require expenditure initially but are meant to generate future profits. The objective
of the firm is thus to maximise the present or discounted value of all future profits
and can be stated as:
π1 π2 πn
PV(π) = + + ............... +
(1 + r ) 1
(1 + r ) 2
(1 + r ) n
n
πt
= ∑ (1 + r)
t =1
t

Where, PV = Present Value of all expected future profits of the firm.

p ..p n = Expected profit in 1, 2........................n years.
r = Appropriate discount rate
t = Time period 1 ……….n.

Assumed profit is equal to total revenue (TR) minus total cost (TC), then the value
of the firm can also be stated as:
n
TRt − TC t
Value of the firm = ∑
t =1 (1 + r ) t

Thus maximising the discounted value of all future profits is equivalent to

maximising the value of the firm.

A careful inspection of the equation suggests how a firm’s managers and workers
can influence its value. For example, in a company, the marketing managers and
sales representatives work hard to increase its total revenues, while its production
managers and manufacturing engineers strive to reduce its total costs. At the same
6 time, its financial managers play a major role in obtaining capital, and hence
influence the equation, while its research and development personnel invent and
reduce its total costs. All of these diverse groups affect the company’s value,
defined here as the present value of all expected future profits of the firm.
Figure 2.2: Determination of the value of the firm

n
TR t − TC t
∑
t =1 (1 + r ) t

The value of r Value of TRt Value of TCt

depends on: depends on: depends on:
1. Riskiness of 1. Demand and 1. Production
firm forecasting techniques
2. Conditions in 2. Pricing 2. Cost functions
capital market 3. New product 3. Process development
development

2.4 ALTERNATIVE OBJECTIVES OF FIRMS

Economists have also examined other objectives of firms. We shall discuss some of
them here. According to Baumol, most managers will try to maximise sales
revenue. There are many reasons for this. For example, the salary and other
earnings of managers are more closely related to sales revenue than to profits.
Banks and financers look at sales revenue while financing the corporation. The
sales revenue trend is a readily available indicator of performance of the firm.
Growth in sales increases the competitive strength of the firm. However, in the long
run, sales maximisation and profit maximisation may converge into one objective.

Another economist Robin Marris assumes that owners and managers have
different utility functions to maximise. The manager’s utility function (Um) and
Owner’ utility functions (Uo) are:
Um = f (Salary, job, power, prestige, status)
Uo = f (Output, capital, profit, share)

By maximising the variables, managers maximise both their own utility function and
that of the owners. Most of the variables of both managers and owners are
correlated with a single variable, namely, the size of the firm. Maximisation of these
variables depends on the growth rate of the firm. Thus, Marris argues that
managers will attempt to maximise growth rate of firms. However, this objective
does not completely discard the profit maximisation objective.

According to Oliver Williamson, managers seek to maximise their own utility

function subject to a minimum level of profit. The utility function which managers
seek to maximise include both quantifiable variables like salary and slack earnings
and non-quantifiable variables like power, status, security of job, etc. The model
developed by Cyert-March focuses on satisficing behaviour of managers. The firm
has to deal with an uncertain business world and managers have to satisfy a variety 7
Introduction to Managerial
of groups-staff, shareholders, customers, suppliers, authorities, etc. All these groups The Firm: Stakeholders,
Economics Objectives and Decision
have often-conflicting interests in the firm. In order to reconcile between the Issues
conflicting interests and goals, managers form an aspiration level of the firm
combining the following objectives – production, sales and market share, inventory
and profit. The aspiration levels are modified and revised on the basis of
achievements and changing business environment.

As is true with most economic models, the application will depend upon the situation
and one cannot say that a particular model is better than the other. In general, one
can assert that the profit maximising assumption seems to be a reasonable
approximation of the real world, although in certain cases there might be a deviation
from this objective.

2.5 GOALS OF REAL WORLD FIRMS

By now we know that firms that maximise profits are not just concerned about
short-run profits, but are more concerned with long-term profits. They may not take
full advantage of a potential monopolistic situation, for example, many stores have
liberal return policies; many firms spend millions on improving their reputation and
want to be known as ‘good’ citizens. The decision maker’s income is often a cost
of the firm. Most real-world production takes place in large corporations with 8-9
levels of management, thousands of stockholders and boards of directors. Self-
interested decision makers have little incentive to hold down their pay. If their pay is
not held down, firm’s profit will be lower. Most firms manage to put some pressure
on managers to make at least a pre-designated level of profit.

In the modern corporation, the owners or stockholders (i.e. the principals) hire
managers (i.e., agents) to conduct the day-to-day operations of the firm. These
managers are paid a salary to represent the interest of the owners, ostensibly, to
maximize the value of the firm. A board of directors is elected by the owners to
meet regularly with the managers to oversee their activity and to try to ensure that
the managers are, in fact, acting in the best interest of the owners.

Because of the difficulty of monitoring the managers on a continual basis, it is

possible that goals other than profit-maximization may be pursued. In addition to
those mentioned earlier, the managers may seek to enhance their positions by
spending corporate funds on fancy offices, excessive and expensive travel, club
memberships, and so forth. In recent years, many corporations have taken action to
align the interests of owners with the interests of the managers by tying a large
share of managerial compensation to the financial performance of the firm.

For example, the manager may be given a basic salary plus potentially large
bonuses for meeting such goals as attaining a specified return on capital, growth in
earnings, and/or increase in the price of the firm’s stock. With regard to the latter,
the use of stock options awarded to top managers is a most effective way to ensure
that managers act in the interest of the shareholders. Typically, the arrangement
provides that the manager is to receive an option to buy a specified number of
shares of common stock at the current market price for a specified number of
years. The only way the executives can benefit from such an arrangement is if the
price of stock rises during the specified term. The option is exercised by buying the
shares at the specified price, and the gain equals the increase in share price
multiplied by the number of shares purchased. Sometimes the agreement specifies
that the stock must be held for several years following purchase. Essentially, this
option arrangement makes the manager a de facto owner, even if the option has
not been exercised. In almost every case of a report of unusually high executive
compensation, the largest part of that compensation is associated with gains from
8 stock options.
Emergence of oligopoly, a market structure characterized by the existence of a few
large firms, mergers and amalgamations have made the structure of industries
concentrated so that few large (dominant) firms account for a major portion of an
industry’s output. This shifts the pressure on each firm to maximise profit
independently and leads to joint profit maximizations through cartels and collusions.
Profit maximization may not be the only inevitable objective.

India’s Global Companies and their Objectives: One of the most significant
business and economic trends of the late twentieth century is the rise of ‘global’ or
‘stateless’ corporation. The trends toward global companies are unmistakable and
are accelerating. The sharpest weapon that a corporation can develop to survive
and thrive, in the globalised market place is competitiveness. Its corner stone as
articulated by strategy guru Michael Porter is its ability to create more value on a
sustainable basis, for the customer than its rivals can.

For the first time, many Indian corporations such as Reliance Industries, Ranbaxy,
Sundaram Fasteners, Arvind Mills and Bajaj Auto among others are competing on
the world stage. Whatever product or service a company offers it must meet the
customers wants in the most satisfactory manner. This should be the aim of the
company. The competitiveness of Reliance in the global market place comes from
both quality and scale. The challenge is to remain at the top. That challenge is
linked with productivity. Ranbaxy’s greatest strength lies in the fact that it is
strongly backward integrated. It helps them manage cost across the entire value
chain making them extremely cost competitive. Cost leadership is a function of
scale and technology. By upgrading technology, Ranbaxy could continue to be a
cost leader. A company has to continuously upgrade itself on several parameters:
production efficiency, product development, quality management and marketing
skills. Sundaram has programmes to address all these parameters.

This competitiveness - defined by Michael Porter as the sustained ability to

generate more value for customers than the cost of creating that value - is what
will keep India’s Companies alive in the bitter battle for survival that they are
waging even on their home turf with rivals pouring in from all corners of the globe.

2.6 FIRM’S CONSTRAINTS

Decision-making by firms takes place under several restrictions or constraints, such
as:

Resource Constraints: Many inputs may be available in a limited or fixed

quantity e.g., skilled workers, imported raw material, etc.

Legal Constraints: Both individuals and firms have to obey the laws of the State
as well as local laws. Environmental laws, employment laws, disposal of wastes are
some examples.

Moral Constraints: These imply to actions that are not illegal but are sufficiently
consistent with generally accepted standards of behaviour.

Contractual Constraints: These bind the firm because of some prior agreement
such as a long-term lease on a building or a contract with a labour union that
represents the firm’s employees.

Decision-making under these constraints with optimal results is a fundamental part

of managerial economics.

9
Introduction to Managerial The Firm: Stakeholders,
2.7 BASIC FACTORS OF DECISION-MAKING:
Economics Objectives and Decision
THE INCREMENTAL CONCEPT Issues

Incremental reasoning involves estimating the impact of decision alternatives. The

two basic concepts in the incremental analysis are:
Incremental Cost (IC)
Incremental Revenue (IR)
Incremental cost is defined as the change in total cost as a result of change in the
level of output, investment etc. Incremental revenue is defined as the change in
total revenue resulting from a change in the level of output, prices etc. A manager
always determines the worth of a decision on the basis of the criterion that IR>IC.

A decision is profitable if
it increases revenue more than it increases cost
it reduces some costs more than it increases others
it increases some resources more than it decreases others
it decreases costs more than it decreases revenues.

To illustrate the above points, let us take a case where a firm gets an order that can
get it additional revenue of Rs. 2,000. The normal cost of production of this order is–

Labour : Rs. 600

Materials : Rs. 800
Overheads : Rs. 720
Selling and administration expenses : Rs. 280
Full cost : Rs. 2,400

Comparing the additional revenue with the above cost suggests that the order is
unprofitable. But, if some existing facilities and underutilised capacity of the firm
were utilised, it would add much less to cost than Rs. 2,400. For example, let us
assume that the addition to cost due to this new order is, say, the following:

Labour : Rs. 400

Materials : Rs. 800
Overheads : Rs. 200
Total incremental Cost : Rs. 1,400

In the above case the firm would earn a net profit of Rs. 2000 – Rs. 1400 = Rs. 600,
while at first it appeared that the firm would make a loss of Rs. 400 by accepting
the order.
The worth of such a decision can be judged on the basis of the following theorem.
Theorem I: A course of action should be pursued upto the point where its
incremental benefits equal its increment costs.
According to the theorem, the firm represented in Table 2.1 will produce only seven
units of output as its Marginal Revenue (MR)= Marginal Cost (MC)1 at that level
of output. As can be calculated from the Table, the MC of 8th unit is more than its

1
Marginal Revenue is the additional revenue from selling one more unit, while Marginal Cost is the
10 additional cost of producing one more unit.
MR. Hence the firm gets negative profit from 8th unit and thus is advised not to
produce it.

The acceptance or rejection of an order by a firm for its product depends on

whether the resultant costs are greater or less than the resultant revenue. If these
principles are not followed, the equilibrium position would be disturbed. But the
problem with the concept of marginalism is that the independent variable may be
subject to “bulk changes” instead of “unit changes”. For example, a builder may not
change one labourer at a time, but many of them together. Similarly, the output may
change because of a change in process, pattern or a combination of factors, which
may not always be measured in unit terms. In such cases, the concept of
marginalism is changed to incrementalism. Or, in other words, incrementalism is
more general, whereas marginalism is more specific. All marginal concepts are
incremental concepts, but all incremental concepts need not be marginal concepts.

Table 2.1 : Profit Function of a Firm

Unit of Total Total Cost Total Profit Average Marginal

Output Revenue Profit Profit
1 2 3 4 5 6

1 20 15 5 5.0 -

2 40 29 11 5.5 6

3 60 42 18 6.0 7

4 80 52 28 7.0 10

5 100 65 35 7.0 7

6 120 81 39 6.5 4

7 140 101 39 5.6 0

8 160 125 35 4.4 -4

2.8 THE EQUI-MARGINAL PRINCIPLE

According to this principle, different courses of action should be pursued upto the
point where all the courses provide equal marginal benefit per unit of cost. It states
that a rational decision-maker would allocate or hire his resources in such a way
that the ratio of marginal returns and marginal costs of various uses of a given
resource or of various resources in a given use is the same. For example, a
consumer seeking maximum utility (satisfaction) from his consumption basket, will
allocate his consumption budget on goods and services such that

MU1/MC = MU2 / MC2 =……..= MUn / MCn,

Where MU 1 = marginal utility from good one,
MC1 = marginal cost of good one and so on.

Similarly, a producer seeking maximum profit would use the technique of production
(input-mix.) which would ensure
11
Introduction
MRPto1/MC
Managerial
= MRP2/MC2 =………….=MRPn/MCn The Firm: Stakeholders,
1
Economics Objectives and Decision
Issues
Where MRP1=Marginal revenue product of input one (e.g. Labour), MC1=
Marginal cost of input one and so on.

It is easy to see that if the above equation was not satisfied, the decision makers
could add to his utility/profit by reshuffling his resources/input e.g. if MU1/
MC1>MU2/MC2 the consumer would add to his utility by buying more of good one
and less of good two. Table 2.2 summarises this principle for different sellers.

Example: A multi-commodity consumer wishes to purchase successive units of

A,B and C. Each unit costs the same and the consumer is determined to have a
combination including all the three items. His budget constraint is such that he
cannot buy more than six units in all. Again, he is subject to diminishing marginal
utility i.e. as he has more of an item, he wants to consume less of it. Table 2.3
shows the optimisation example:

Table 2.2: The Equi-Marginal Principle

Unit Equi-Marginal Principle

Multi-market seller MR1=MR2=MR3=...........MRn
Multi-plant monopolist MC1=MC2=MC3=...........MCn
Multi-factor employer MP1=MP2=MP3=...........MPn
Multi-product firm Mp1=Mp2=Mp3=...........Mpn
Multi-commodity consumer MU1=MU2=MU3=...........Mu
MR=marginal revenue; MC=marginal cost; MP=marginal product;
Mp =marginal profit; MU=marginal utilities.

Table 2.3 : Optimisation Example

MARGINAL UTILITIES
Units Item A Item B Item C
1 10 9 8
2 9 8 7
3 8 7 6
4 7 6 5
5 6 5 4
6 5 4 3

The utility maximising consumer will end up with a purchase of 3A+2B+1C

because that combination satisfies equimarginalism:

MUa=MUb=MUc=8

In the real world, often the equi-marginalism concept has to be replaced by equi-
incrementalism. This is because, changes in the real world are discrete or lumpy
and therefore the concept of marginal change may not always apply. Instead,
changes will be incremental in nature, but the decision rule or optimising principle
will remain the same.

12
2.9 THE DISCOUNTING PRINCIPLE
Many transactions involve making or receiving cash payments at various future
dates. A person who takes a house loan trades a promise to make monthly
payments for say, fifteen or twenty years for a large amount of cash now to pay
for a home. This case and other similar cases relate to the time value of money.
The time value of money refers to the fact that a rupee to be received in the future
is not worth a rupee today. Therefore, it is necessary to have techniques for
measuring the value today (i.e., the present value) of rupees to be received or paid
at different points in the future. This section outlines the approach to analyzing
problems that involve payment and/or receipt of money at one or more points in
time.

One may ask how much money today would be equivalent to Rs. 100 a year from
now if the rate of interest is 5%. This involves determining the present value of
Rs. 100 to be received after one year. Applying the formula –
100
PV =
1.05
we obtain Rs. 95.24,

Rs. 95.24 will accumulate to an amount exactly equal to Rs. 100 in one year at the
interest rate of 5 per cent. Looked at another way, you will be willing to pay
maximum of Rs. 95.24 for the benefit of receiving Rs. 100 one year from now if
the prevailing interest rate is 5 per cent.

The same analysis can be extended to any number of periods. A sum of Rs. 100
two years from now is worth:
100
PV2 =
2
1.05
= Rs.90.70 today.

In general, the present value of a sum to be received at any future date can be
found by the following formula:
Rn
PV = n
(1 + i )
PV = present value, Rn = amount to be received in future, i = rate of interest, n =
number of years lapsing between the receipt of R.

If the receipts are made available over a number of years, the formula becomes:
R1 R2 R3 Rn
PV = + + + ............ + n
1+ i 2 3 (1 + i)
(1 + i) (1 + i)

n Rk
PV =∑ k
K =1 (1 + i )

In the above formula if R1 = R2= R3 etc., it becomes an ‘annuity’. An annuity has

been defined as series of periodic equal payments. Although the term is often
thought of in terms of a retirement pension, there are many other examples of
annuities. The repayment schedule for a home loan is an annuity. A father’s
agreement to send his son Rs. 1000 each month while he is in college is another
example. Usually, the number of periods is specified, but not always. Sometimes
retirement benefits are paid monthly as long as a person is alive. In other case, the
annuity is paid forever and is called ‘perpetuity.’
13
Introduction to Managerial
It must be emphasized that the strict definition of an annuity implies equal The Firm: Stakeholders,
Economics Objectives and Decision
payments. A contract to make 20 annual payments, which increase each year by, Issues
say, 10 per cent, would not be an annuity. As some financial arrangements provide
for payments with periodic increase, care must be taken not to apply an annuity
formula if the flow of payments is not a true annuity.

The present value of an annuity can be thought of as the sum of the present values
of each of several amounts. Consider an annuity of three Rs. 100 payments at the
end of each of the next three years at 10 percent interest. The present value of
each payment is
1
PV1 = 100
1.10

1
PV2 = 100
2
1.10

1
PV3 = 100
3
1.10
and the sum of these would be
1 1 1
PV = 100 + 100 + 100
1.10 2 3
(1.10) (1.10)

OR

⎡ 1 1 1 ⎤
PV = 100 ⎢ + +
2 3⎥
⎣1.10 (1.10) (1.10) ⎦

The present value of this annuity is

PV = 100 (0.9091 + 0.8264 + 0.7513) = 100 (2.4868) = 248.68

Although this approach works, it clearly would be cumbersome for annuities of

more than a few periods. For example, consider using this method to find the
present value of a monthly payment for forty years if the monthly interest rate is 1
per cent. That would require evaluating the present value of each of 480 amounts!
In general, the formula for the present value of an annuity of A rupees per period
for n periods and a discount rate of i is
1 1 1
PV = A +A + ⋅⋅⋅⋅ + A n
(1 + i ) 2 (1 + i)
(1 + i )

2.10 THE OPPORTUNITY COST PRINCIPLE

The opportunity cost of anything is the return that can be had from the next best
alternative use. A farmer who is producing wheat can also produce potatoes with
the same factors. Therefore, the opportunity cost of a quintal of wheat is the
amount of the output of potatoes given up. The opportunity costs are the ‘costs of
sacrificed alternatives.’

Whenever the manager takes a decision he chooses one course of action,

sacrificing the other alternative courses. We can therefore evaluate the one, which
is chosen in terms of the other (next best) alternative that is sacrificed. A machine
can produce either X or Y. The opportunity cost of producing a given quantity of X
14 is the quantity of Y which it would have produced.
The opportunity cost of holding Rs.1000 as cash in hand for one year is the 10%
rate of interest, which would have been earned had it been invested in the form of
fixed deposits in the bank.
all decisions which involve choice must involve opportunity cost calculation,
the opportunity cost may be either real or monetary, either implicit or explicit,
either non-quantifiable or quantifiable.

Opportunity costs’ relevance is not limited to individual decisions. Opportunity costs

are also relevant to government’s decisions, which affect everyone in society. A
common example is the guns-versus-butter debate. The resources that a society
has are limited; therefore its decisions to use those resources to have more guns
(more weapons) means that it must have less butter (fewer consumer goods). Thus
when society decides to spend 100 crore on developing a defence system, the
opportunity cost of that decision is 100 crores not spent on fighting drugs, helping
the homeless, or paying off some of the national debt.

For the country as a whole, the production possibility reflects opportunity costs.
Figure 2.1 shows the Production Possibility Curve (PPC) reflecting the different
combinations of goods, which an economy can produce, given its state of
technology and total resources. It illustrates the menu of choices open to the
economy. Let us take the example that the economy can produce only two goods,
butter and guns. The economy can produce only guns, only butter or a combination
of the two, illustrating the trade offs or choice inherent in such a decision. The
opportunity cost of choosing guns over butter increases as the production of guns is
increased. The reason is that some resources are relatively better suited to
producing guns. The quantity of butter, which has to be sacrificed to produce an
additional unit of guns, is called the opportunity cost of guns (in terms of butter).
Due to the increasing opportunity cost of guns, the PPC curve will be concave to
the origin. Increasing opportunity cost of guns means that to produce each
additional unit of guns, more and more units of butter have to be sacrificed. The
basis for increasing opportunity costs is the following assumptions:

i) Some factors of production are more efficient in the production of butter and
some more efficient in production of guns. This property of factors is called
specificity. Thus specificity of factors of production causes increasing
opportunity costs.

Figure 2.1: Production Possibility Curve

Butter

Guns
15
Introduction to Managerial
Figure 2.2: Production Possibility Curve - Linear The Firm: Stakeholders,
Economics Objectives and Decision
Issues
Butter

0 Guns
1 2 3 4

ii) The production of the goods require more of one factor than the other. For
example, the production of guns may require more capital than that of butter.
Hence, as more and more of capital is used in the manufacture of guns, the
opportunity cost of guns is likely to increase.

Let us assume that an economy is at point A where it uses all its resources in the
production of butter. Starting from A, the production of 1 unit of guns requires that
AC units of butter be given up. The production of a second unit of guns requires
that additional CD units of butter be given up. A third requires that DE be given up,
and so on. Since DE>CD>AC, and so on, it means that for every additional unit of
guns more and more units of butter will have to be sacrificed, or in other words, the
opportunity cost keeps on increasing.

The opportunity cost of the first few units of guns would initially be low and those
resources, which are more efficient in the production of guns move from, butter
production to gun production. As more and more units of guns are produced,
however, it becomes necessary to move into gun production, even for those factors,
which are more efficient in the production of butter. As this happens, the
opportunity cost of guns gets larger and larger. Thus, due to increasing opportunity
costs the PPC is concave.

If the PPC curve were to be a straight line, the opportunity cost of guns would
always be constant. This would mean equal (and not increasing amounts of butter)
would have to be forgone to produce an additional unit of guns. The assumption of
constant opportunity costs is very unrealistic. It implies that all the factors of
production are equally efficient either in the production of butter or in the production
of guns.

For many of the choice society make opportunity costs tend to increase as we
choose more and more of an item. Such a phenomenon about choice is so common,
in fact, that it has acquired a name: the principle of increasing marginal opportunity
cost. This principle states that in order to get more of something, one must give up
ever-increasing quantities of something else. In other words, initially the opportunity
costs of an activity are low, but they increase the more we concentrate on that
activity.
16
2.11 THE INVISIBLE HAND
Adam Smith, the father of modern economics believed that there existed an
“invisible hand” which ruled over the economic system. According to him the
economic system, left to itself, is self-regulating. The basic driving force in such a
system is trying to enhance its own economic well-being. But the actions of each
unit, acting according to its own self-interest, are also in the interests of the
economy as a whole.

Producers are led by the profit motive to produce those goods and services which
the consumers want. They try to do this at the minimum possible cost in order to
maximize their profits. Moreover, if there is competition among a number of
producers, they will each try to keep the price of their product low in order to
attract the consumers. The goods produced are made available in the market by
traders. They also act in their own self-interest. However, in a self-regulating
economy, there is rarely any shortage of goods and services.

Decisions to save and invest are also taken by the individual economic units. For
example, households save some of their income and deposit part of it in the banks,
or invest it in shares and debentures and so on. The producers borrow from the
banking system and also issue shares and debentures to finance their investments.
In turn, they reinvest a part of their profits.

All the economic functions have been carried out by individuals acting in isolation.
There is no government or centralized authority to determine who should produce
what and in what quantity, and where it should be made available. Yet in a self-
regulating economy there is seldom a shortage of goods and services. Practically
everything you want to buy is available in the market. Thus according to Adam
Smith, the economic system is guided by the “invisible hand”. In a more technical
way we can say that the basic economic problems in a society are solved by the
operation of market forces.

2.12 SUMMARY
There is a circular flow of economic activity between individuals and firms as they
are highly interdependent. The firms’ existence is based on manifold reasons. Firms
are classified into different categories. Different firms belonging to the same
industry, facing the same market environment, behave differently. Thus, the
necessity for theories of the firm. Profit is defined as revenues minus costs. But the
definition of cost is quite different for economist than for the accountant. Short-
term profit has been sidelined by most firms as their objective for increasing the
future long-term profit. Real world firms often have a set of complicated goals. The
basic factors of decision making can be outlined by various principles.

2.13 SELF-ASSESSMENT QUESTIONS

1. Write notes in about 200 words on the following:

a) The incremental concept
b) Opportunity cost
c) Scope of managerial economics
d) The Invisible Hand
2. ‘Managerial Economics serves as a link between traditional economics and
decision sciences for business decision-making.’ Elucidate.
3. Calculate, using the best estimates you can make:
a) Your opportunity cost of attending college. 17
Introductionb)toYour
Managerial
opportunity cost of taking this course. The Firm: Stakeholders,
Economics Objectives and Decision
c) Your opportunity cost of attending yesterday’s lecture of your course. Issues

4. The following is the hypothetical production possibility table of India:

Resources Devoted to Output of Clothing Output of Food

Clothing
100% 20 0
80 % 16 5
60 % 12 9
40 % 8 12
20 % 4 14
0% 0 15

a) Draw India’s production possibility curve.

b) What is happening to marginal opportunity costs as output of food increases?
c) If the country gets better at the production of food, what will happen to the
production possibility curve?
d) If the country gets equally better at producing food and producing clothing,
what will happen to the production possibility curve?
5. Use the following interest rates for government bonds for the risk-free discount
rate and answer the following:

Time of Maturity (years) Interest Rate (%)

1 5.75
2 6.00
3 6.25
4 6.50
5 6.75

(i) Calculate the PV of a Rs. 1 lakh payment to be received at the end of one
year, 2 years, 3 years, 4 years and 5 years.
(ii)What is the present value of a firm with a 5 years life span that earns the
following stream of expected profit at the year-end?

Years Expected Profit (in Crores)

1 10
2 20
3 50
4 25
5 50

6. Value maximisation has become the major objective of a modern firm.

Comment.

2.14 FURTHER READINGS

Joel Dean, Managerial Economics, Asia Publishing House, Bombay.

Mote, Paul Gupta, Managerial Economics, Tata McGraw Hill.

Koutsoyiannis, Modern Microeconomics, The Macmillan Press Pvt. Ltd.

18