Managerial Economics

Basic Concepts and Principles

 Lecture plan
• Objectives
• What is Economics?
• Basic Assumptions
• Types of Economic Analysis
• Managerial Economics
• Managerial Decisions
• Economic Principles Relevant to Managerial Decisions
• Production Possibilities Curve
• Managerial Economics and Functions of Management
• Relationship with Other Disciplines
• Summary
 Objectives
• To introduce key economic concepts like scarcity, rationality,
equilibrium, time perspective and opportunity cost.

• To explain the basic difference between microeconomics and

macroeconomics.

• To help the reader analyze how decisions are made about what, how
and for whom to produce.

• To define managerial economics and demonstrate its importance in

managerial decision making.

• To discuss the scope of managerial economics and its relationship

with various other disciplines and functional areas.
 What is Economics?
• Discusses how a society tries to solve the human problems of
unlimited wants and scarce resources.
• Scientific study of the choices made by individuals and societies
with regard to the alternative uses of scarce resources
employed to satisfy wants.
• Theoretical aspect and an applied science in its practical
aspects.
• Not an exact science; An “art” as well
• A social science
• Deals with the society as a whole and human behaviour in
particular
• Studies the production, distribution, and consumption of goods
and services.
• A science in its methodology, and art in its application.
 Basic Assumptions

• Ceteris Paribus
– Latin phrase
– “With other things (being) the same” or “all other things
being equal”.
• Rationality
– Consumers maximize utility subject to given money
income.
– Producers maximize profit subject to given resources or
minimize cost subject to target return.
 Types of Economic Analysis

• Micro and Macro

– Microeconomics (“micro” meaning small): study of the behaviour
of small economic units
• An individual consumer, a seller/ a producer/ a firm, or a product.
• Focus on basic theories of supply and demand in individual
markets
– Macroeconomics (“macro” meaning large): study of
aggregates.
• Industry as a unit, and not the firm.
• Focus on aggregate demand and aggregate supply, national
income, employment, inflation, etc.
 Types of Economic Analysis

• Positive and Normative

– Positive economics: “what is” in economic matters
• Establishes a cause and effect relationship between variables.
• Analyzes problems on the basis of facts.
– Normative economics: “what ought to be” in economic
matters.
• Concerned with questions involving value judgments.
• Incorporates value judgments about what the economy should be
like.
 Types of Economic Analysis
contd..

• Short Run and Long Run

– Short run: Time period not enough for consumers and
producers to adjust completely to any new situation.
• Some inputs are fixed and others are variable
– Long run: Time period long enough for consumers and
producers to adjust to any new situation.
• All inputs are variable
• Decisions to adjust capacity, to introduce a larger plant
or continue with the existing one, to change product
lines.
 Types of Economic Analysis
• Partial and General Equilibrium
– Partial equilibrium analysis: Related to micro analysis
• Studies the outcome of any policy action in a single
market only.
• Equilibrium of one firm or few firms and not necessarily
the industry or economy.
– General equilibrium: explains economic phenomena in an
economy as a whole.
• State in which all the industries in an economy are in
equilibrium.
• State of full employment
 Managerial Economics

• Application of economic theory and the tools of analysis of

decision science to examine how an organisation can achieve
its objectives most effectively
• Study of allocation of the limited resources available to a firm
or other unit of management among the various possible
activities of that unit
• Applies economic theory and methods to business and
administrative decision-making
• Application of economic principles and methodologies to the
decision-making process within the firm or organization
 Managerial Economics
Contd…

• Micro as well as Macro

– Applied microeconomics: demand analysis, cost and production
analysis, pricing and output decisions
– Macroeconomic: national income, inflation and stages of recession
and expansion
• Normative Bias
– Prescriptive: States what firms should do in order to reach certain
objectives.
– Decides on whether or not the probable outcome of a managerial
decision is desirable.
• Decisions Resulting in Partial Equilibrium
– Decisions taken by any firm would relate to the equilibrium of that
particular firm.
– Deals with partial equilibrium analysis
 Economic Principles Relevant to
Managerial Decisions
• Concept of scarcity
– Unlimited human wants
– Limited resources available to satisfy such wants
– Best possible use of resources to get:
• maximum satisfaction (from the point of view of consumers) or
• maximum output (from the point of view of producers or firms)
• Concept of opportunity cost
– Opportunity cost is the benefit forgone from the alternative that is not
selected.
– Highlights the capacity of one resource to satisfy multitude of wants
– Helps in making rational choices in all aspects of business, since resources
are scarce and wants are unlimited
 Economic Principles Relevant to
Managerial Decisions Contd…
• Concept of margin or increment
– Marginality: a unit increase in cost or revenue or utility.
• Marginal cost: change in Total Cost due to a unit change in output.
• Marginal revenue: change in Total Revenue due to a unit change in
sales.
• Marginal utility: change in Total Utility due to a unit change in
consumption.
– Incremental: applied when the changes are in bulk, say
10% increase in sales.
 Economic Principles Relevant to
Managerial Decisions
• Discounting Principle
– Time value of money : Value of money depreciates with
time
• A rupee in hand today is worth more than a rupee received
tomorrow.
– Outflow and inflow of money and resources at different
points of time

PVF = 1
(1 + r) n
where
PVF = Present Value of Fund,
n = period (year, etc.)
R = rate of discount
 Production Possibilities Curve
• Highlights the concepts of scarcity and opportunity cost
– Indicates the opportunity cost of increasing one item's production (or
consumption) in terms of the units of the other forgone
– Slope of the curve in absolute terms
• Assumptions
– The economy is operating at full employment.
– Factors of production are fixed in supply; they can however be
reallocated among different uses.
– Technology remains the same.
 Production Possibilities Curve
• Shows the different
combinations of the quantities of
Technically two goods that can be produced
Food Infeasible Area (or consumed) in an economy at
any point of time.
P
FP • Below the curve is productively
inefficient area and above it is
FQ Q technically infeasible area, so
Productively the equilibrium will be at the
Inefficient Area curve (FP and CP at point P).
• Depicts the trade off between
any two items produced (or
O consumed).
CP CQ Clothing
• To increase the quantity of
clothing from CP to CQ some
PPC for the Society amount of food (FP-FQ) will have
to be sacrificed. New point of
equilibrium on PPC is at Q.
 Production Possibilities Curve
Contd…

• All points on the PPC (like P and Q) are points of maximum productive
efficiency.
• In the figure, OFp of food and OCp of clothing can be produced at Point P
and OFQ of food and OCQ respectively at point Q, when production is run
efficiently.
• All points inside the frontier are feasible but productively inefficient.
• All points to the right of (or above) the curve are technically impossible
(or cannot be sustained for long).
• A move from P to Q indicates an increase in the units of clothing produced
and vice versa.
• It also implies a decrease in the units of food produced. This decrease in
the units of food is the opportunity cost of producing more clothing.
 Managerial Economics and Functions of
Management

• All functional areas have to find the most

efficient way of allocating scarce
organizational resources
• Managerial economics:
– Facilitates the process of evaluating relationships
between functional areas
– Helps in making rational decisions across
managerial functions.
 Managerial Economics and FunctionsContd…
of
Management
• Financial Management
– From where to collect resources
• Equity
• Debt
– How to allocate resources
– How much profit to be retained/distributed
• Human Resource Management
– Recruitment
– Wage and Salary
– Training and development
– Retirement
 Managerial Economics and Functions of
Management
• Marketing Management
– Which product
– For whom
– What price
– How to sell
• Operations Management
– Which technology
– Inputs
– Processing
• Information System Management
– Communication channels
 Relationship Other Disciplines
Economic Theory
Microeconomics Quantitative Analysis
•Theory of firm •Numeric and algebraic analysis
•Theory of consumer behaviour (demand) •Optimization
•Production and cost theory (supply) •Discounting and time value of money
•Market structure and competition techniques
•Price theory •Statistical estimation and forecasting
Macroeconomics
•Game theory
•National income and output
•Business cycle
•Inflation

Managerial Economics

Solutions to Managerial Decision Making

•Quantity and quality of product
•Price of product
•Marketing Management
•Financial Management
•Human Resource Management
•Research and Development
 Summary
• Economics studies the choices made by individuals and societies in regard
to the alternative uses of scarce resources which are employed to satisfy
unlimited wants.
• Microeconomics is the study of the behaviour of individual economic units,
such as an individual consumer, a seller, a producer, a firm, or a product.
• Macroeconomics deals with the study of aggregates, the economy as a
whole.
• Ceteris paribus is a Latin phrase, literally translated as “with other things
(being) the same”.
• The assumption of rationality means that consumers and firms measure
and compare the costs and benefits of a decision before going ahead for
that decision.
• Partial equilibrium analysis studies the outcome of any policy action in a
single market only, while general equilibrium analysis seeks to explain
economic phenomena in an economy as a whole.
• Opportunity cost is the benefit forgone from the alternative that is not
selected.
 Summary
• Concept of Time value of money tells that Value of money
depreciates with time.
• Concept of Marginal/increment tells about impact of
unit/proportionate change in cost/revenue on decision making.
• Managerial economics is a means to finding the most efficient way
of allocating scarce organizational resources and reaching stated
objectives. It is micro as well as macro in nature; it has a normative
bias, and deals with partial equilibrium.
• Production Possibilities Curve (PPC) is a graph that shows the
different combinations of the quantities of two goods that can be
produced (or consumed) in an economy, subject to the limited
availability of resources.
• The knowledge of managerial economics helps to understand the
interrelationships among the various functional units of any firm
(namely production, marketing, HR, finance, IT and legal)
• Decision sciences provide the tools and techniques of analysis used
in managerial economics, in particular numerical and algebraic
analysis, optimization, statistical estimation and forecasting.