QUESTION & ANSWER BANK

Q1. Write a short note on ‘Incremental Concept’?

Ans. The incremental concept is probably the most important concept in economics and is certainly the
most frequently used in Managerial Economics. Incremental concept is closely related to the marginal
cost and marginal revenues of economic theory.

The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost
denotes change in total cost, whereas incremental revenue means change in total revenue resulting
from a decision of the firm.

The incremental principle may be stated as follows:

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

(iv) It reduces costs more than revenues.

Q2. Note down the details of the limitations of the Incremental Concept.

Ans. The Incremental concept is mainly used by the progressive concerns. Even though it is a widely
followed concept, it has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm is always variable.

(b) The concept can be applied only when there is excess capacity in the concern.

(c) The concept is applicable only during the short period.

Q3. Point out the grounds of criticism of the behavioural theory of Cyert and March.

Ans. The behavioural theory of Cyert and March has been severely criticized on the following major
grounds:
(1) The critics feel that the behavioural theory is specific a duopoly firm and fails as the theory of market
structures.

(2) The theory does not consider either the conditions of entry or the effects on the behaviour of
existing films of a threat of potential entry by firms.

(3) The behavioural theory explains the short-run behaviour of firms and ignores their long-run
behaviour.

Despite these criticisms, the behavioural theory of Cyert and March is an important contribution to the
theory of the firm which brings into focus ‘multiple, changing and acceptable goals’ in managerial
decision-making.

Q4. Define Managerial Economics as per Mansfield and Spencer.

Ans. According to Mansfield, “Managerial economics is concerned with the application of economic
concepts and economics to the problems of formulating rational decision making.”

In the words of Spencer, “Managerial economics is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by management”

Q5. For what reasons is managerial economics called a science?

Ans. Managerial Economics is an essential scholastic field. It can be compared to science in a sense that
it fulfills the criteria of being a science in following sense:

Science is a Systematic body of Knowledge. It is based on the methodical observation. Managerial

economics is also a science of making decisions with regard to scarce resources with alternative
applications. It is a body of knowledge that determines or observes the internal and external
environment for decision making.

In science any conclusion is arrived at after continuous experimentation. In Managerial economics also
policies are made after persistent testing and trailing. Though economic environment consists of human
variable, which is unpredictable, thus the policies made are not rigid. Managerial economist takes
decisions by utilizing his valuable past experience and observations.

Science principles are universally applicable. Similarly policies of Managerial economics are also
universally applicable partially if not fully. The policies need to be changed from time to time depending
on the situation and attitude of individuals to those particular situations. Policies are applicable
universally but modifications are required periodically.

Q6. How is Managerial Economics related to art?

Ans. Managerial economist is required to have an art of utilizing his capability, knowledge and
understanding to achieve the organizational objective. Managerial economist should have an art to put
in practice his theoretical knowledge regarding elements of economic environment.

Q7. How is macro economics important to managerial economics?

Ans. None of the organization works in isolation. They are affected by the external environment of the
economy in which it operates such as government policies, general price level, income and employment
levels in the economy, stage of business cycle in which economy is operating, exchange rate, balance of
payment, general expenditure, saving and investment patterns of the consumers, market conditions etc.
These aspects are related to macro economics.

Q8. Why is managerial economics dynamic in nature?

Ans. Managerial Economics deals with human-beings (i.e. human resource, consumers, producers etc.).
The nature and attitude differs from person to person. Thus to cope up with dynamism and vitality
managerial economics also changes itself over a period of time.

Q9. Describe any two approaches to Managerial Economics.

Ans. All managers take the concept of managerial economics differently. Some may be more focused on
customer’s satisfaction while others may prioritize efficient production.

The various approaches to managerial economics can be seen in detail below:

Liberal Managerialism: A market is a democratic place where people are liberal to make their choices
and decisions. The organization and the managers have to function according to the customer’s demand
and market trend; else it may lead to business failures.

Normative Managerialism: The normative view of managerial economics states that administrative
decisions are based on real-life experiences and practices. They have a practical approach to demand
analysis, forecasting, cost management, product design and promotion, recruitment, etc.

Radical Managerialism: Managers must have a revolutionary attitude towards business problems, i.e.
they must make decisions to change the present situation or condition. They focus more on the
customer’s requirement and satisfaction rather than only profit maximization.

Q10. Describe the principles given by macroeconomist N. Gregory Mankiw for the significance of
managerial economics.
Ans. The great macroeconomist N. Gregory Mankiw has given ten principles to explain the significance
of managerial economics in business operations.

These principles are classified as follows:

 Principles of How People Make Decisions
 Principles of How People Interact
 Principles of How Economy Works As A Whole

Principles of How People Make Decisions

To understand how the decision making takes place in real life, let us go through the following
principles:

i. People Face Tradeoffs: To make decisions, people have to make choices where they have to
select among the various options available.
ii. Opportunity Cost: Every decision involves an opportunity cost which the cost of those options
which we avoid while selecting the most appropriate one.
iii. Rational People Think at the Margin: People usually think about the margin or the profit they
will earn before investing their money or resources at a particular project or person.
iv. People Respond to Incentives: Decisions making highly depends upon the incentives associated
with a product, service or activity. Negative incentives discourage people, whereas positive
incentives motivate them.

Principles of How People Interact

Communication and market affect business operations. To justify the statement, let us see the following
related principles:

i. Trade Can Make Everyone Better off: This principle says that trade is a medium of exchange
among people. Everyone gets a chance to offer those products or services which they are good
at making. And purchase those products or services too, which others are good at
manufacturing.
ii. Markets Are Usually A Good Way to Organize Economic Activity: Markets mostly act as a
medium of interaction among the consumers and the producers. The consumers express their
needs and requirement (demands) whereas the producers decide whether to produce goods or
services required or not.
iii. Governments Can Sometimes Improve Market Outcomes: The government intervenes in
business operations at the time of unfavorable market conditions or for the welfare of society.
One such example is when the government decides minimum wages for labor welfare.

Principles of How Economy Works As A Whole

The following principle explains the role of the economy in the functioning of an organization:

i. A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services: For the
growth of the economy of a country, the organizations must be efficient enough to produce
 goods and services. It ultimately meets the consumer’s demand and improves GDP to raise the
country’s standard of living.
ii. Prices Rise When the Government Prints Too Much Money: If there is surplus money available
with people, their spending capacity increases, ultimately leading to a rise in demand. When the
producers are unable to meet the consumer’s demand, inflation takes place.
iii. Society Faces a Short-Run Tradeoff between Inflation and Unemployment: To reduce
unemployment, the government brings in various economic policies into action. These policies
aim at boosting the economy in the short run. Such practices lead to inflation.

Q11. Describe Prof. William Jack Baumol’s model of sales revenue maximisation.

Ans. Baumol’s sales revenue maximization model highlights that the primary objective of a firm is to
maximize its sales rather than profit maximization. It states that the goal of the firm is maximization of
sales revenue subject to a minimum profit constraint. It should be noted that by sales maximization
Baumol does not indicate the maximization of the physical volume of sales but the maximization of the
total revenue of sales, i.e., rupee value of the sales.

Prof. William Jack Baumol, an American Economist has hypothesized maximization of sales revenue. The
rationale in the rear this objective is the dichotomy between management and ownership in large
business corporations. This existing situation of dichotomy provides managers a chance to set their
purpose other than profit maximization goal which most owner-businessmen pursue. Prof. Baumol
thinks that the managers are more interested in maximizing sales rather than profits. So far as empirical
validity of sales revenue maximization objective is concerned, factual evidences are debatable. Despite
of criticism Baumol’s sales maximization model is a major alternative to profit maximization.

Baumol’s sales revenue maximization model highlights that the primary objective of a firm is to
maximize its sales rather than profit maximization. It states that the goal of the firm is maximization of
sales revenue subject to a minimum profit constraint. It should be noted that by sales maximization
Baumol does not indicate the maximization of the physical volume of sales but the maximization of the
total revenue of sales, i.e., rupee value of the sales.

Prof. William Jack Baumol, an American Economist has hypothesized maximization of sales revenue. The
rationale behind this objective is the dichotomy between management and ownership in large business
corporations.

This existing situation of dichotomy provides managers a chance to set their purpose other than profit
maximization goal which most owner-businessmen pursue.

Prof. Baumol thinks that the managers are more interested in maximizing sales rather than profits owing
to the following basic reasons:

(1) The increasing sales add prestige to the managers whereas under the objective of maximization of
profits, the profits go into the shareholders’ pockets.
(2) There are sufficient grounds to understand that the performance and salaries of the top managers
are highly correlated to sales.

(3) The financial and banking institutions consider sales of the firms to gauge their performance and
inclined to finance the firms with rising sales.

(4) Under the situation of sales growing the personnel problems can be more suitably resolved. The
employees at all the levels can be provided with higher emoluments when higher sales take place as
higher sales would indicate better performance.

Baumol’s Sales Maximization Model without Advertising:

Baumol by sales maximization refers to maximization of total revenue. This does not mean the sale of
large quantities of output, but refers to the increase in money sales (in rupee, dollar, etc.). Sales can
increase up to the point of profit maximisation where the marginal cost equals marginal revenue. If sales
are increased beyond this point, money sales may increase at the expense of profits. But the
oligopolistic firm wants its money sales to grow even though it earns minimum profits.

Minimum profits refer to the amount which is less than maximum profits. The minimum profits are
determined on the basis of firm’s need to maximize sales and also to sustain growth of sales. Minimum
pro fits are required either in the form of retained earnings or new capital from the market.

A simple representation of Baumol’s sales maximization model is portrayed in Figure 6.1 where the total
Cost Curve is represented by TC curve, the total revenue curve is represented by TR. The total profit
curve is represented by TP curve. The minimum profit constraint is represented by the line MP. In the
model the firm at OQ level of output the firm maximizes its profit as reflected by the highest point H on
the TP curve. But the aim of the firm in Baumol’s model is to maximize its sales rather than profits.

The sales maximization output of the firm is represented by the OK. Here the total revenue represented
by ZL is the maximum at the highest point of TR curve. We can see that the sales maximizing output OZ
is higher than the profit maximizing output OQ.

But as we know that sales maximization is subject to minimum profit constraint. Let us suppose that the
minimum profit level of the firm is represented by the line PP’.

It is interesting and necessary to observe that the output OZ will not maximize sales while fulfilling the
minimum profit constraint because the minimum profits OP are not being covered by total profits ZS.
For sales maximization subject to minimum profit constraint, ‘i.e. firm should produce the level of
output which not only covers the minimum profits but also attains the highest total revenue consistent
with it. In our representation of Baumol’s model this level is represented by OD level of output where
the minimum profits DC (=OP) are consistent with DE amount of total revenue at the price DE/OD, (i.e.,
total revenue/total output).

It can be pointed out that in Baumol’s model of sales maximisation the profit maximisation output (OQ)
will be smaller than the sales-maximisation output OD, and price higher than under sales maximisation.
The reason for a lower price under sales maximisation is that both total revenue and total output are
equally’ higher while, under profit maximisation, total output is much less as compared to total revenue.
Imagine if QH is joined to TR in Figure 6.1

Baumol’s Sales Maximization Model with Advertising:

Next it would be wise on our part to explore how Baumol in his model has incorporated the impact of
advertising. Prof. Baumol had exhibited that the condition of profit constraint under sales maximization
is also effective in advertising. In this the model we can see that as represented in the Figure 6.2,
expenditure on advertising has been plotted along the horizontal axis. Along the vertical axis the total
revenue, costs and profit are plotted. The TR curve represents the total revenue
As shown in the figure, the advertisement cost curve is depicted by the 45° line AdC. It is deemed that
the other costs of the firm incurred on fixed and variable factors are independent of the advertising cost.
Consequently, by adding a fixed amount of other costs equal to OJ to the AdC curve the total cost curve
TC can be derived. The difference between the TR curve and the TC curve is portrayed by TP curve which
means the total profit curve. The minimum profit constraint line is represented by PP’.

It can be seen from the figure 6.2 that the profit-maximizing firm spends OQ on advertising and its total
revenue will be OL (=QB). On the other hand, given the profit constraint PP’, the sales- maximisation
firm spends OD on advertising and earn OK (=DE) as the total revenue. Thus the sales-maximisation firm
spends more on advertising (OD) than the profit-maximisation firm (OQ), OD > OQ and also earns higher
revenue (DE) than the latter (QB), DE> QB, at the profit constraint PP’. Thus it will always pay the sales
maximiser to increase his advertising outlay until he is stopped by the profit constraint.

Therefore in Baumol’s sales maximization model a sales maximiser would produce at higher level of
output and would keep the prices lower as compared to the profit maximizing firm. The sales maximiser
would spend more on advertising in order to earn larger revenue than the profit maximiser subject to
the minimum profit constraint.

Q12. Explain the representation of Williamson’s Utility Maximization Model.

Ans. To pursue the goal of utility maximization, the manager has a utility function according to which the
manager directs the firm’s resources. Utility of a manager is a function of three variables.

1. Monetary Expenditure on Staff- This variable includes the manager’s compensation package as well as
spending on his subordinate staff. The manager desires to expand his staff and to increase their salaries.
Such monetary expenditure on staff by managers is denoted by S.

2. Managerial Slack – This variable includes additional management perks such as expense accounts,
private convenience, private cars, too many telephone connections and mobiles such expenditures are
characterized as ‘management slack’, M.

3. Discretionary Investment – This variable refers to the amount of undistributed profit available for
manager’s discretional investment or spending. The managers like to have “discretionary funds” for
making investments and spending to promote company projects of his choice. Discretionary investments
are denoted by D.

Thus, the manager’s utility function can be represented as U = f (S, M, D)

Where U represents the utility function, S represents the staff expenditure, M represents the
management slack and D represents the discretionary investments. These decision variables (S, M, D)
yield positive utility and the firm will always choose their values subject to the constraint, S > 0> M > 0, D
> 0. It is also assumed that the law of diminishing marginal utility applies so that when additions are
made to each of staff expenditure, management slack and discretionary investments, they yield smaller
increments of utility to the manager.

Further, Williamson in his model regards price (P) as a function of output (X), expenditure on staff (S),
and the state of environment which he calls ‘a demand shift parameter’ (e), so that –

P = f(X, S, e).

In order to formally represent Williamson’s model, Let us discuss the four different types of profits
introduced by Williamson. They are actual, reported, minimum required and discretionary profits.

We can see that when R represents revenue, C represents total production costs and T represents taxes,
then, actual profits πA = R-C-S

If the amounts of managerial slack or emoluments (M) are deducted from the actual profits, we get
reported profits.

πR = πA =M=R-C-S-M

The minimum required profits, π0, are the lowest level of profits after paying taxes which the
shareholders must receive in order to hold shares of the firm.
Since discretionary profits (D) are what remains with the manager after paying taxes and dividends to
shareholders, therefore,

D = πR – π0 – T

To explain Williamson’s utility maximisation model diagrammatically, it is assumed for the sake of
simplicity that U=f (S, D) so that discretionary profits (Dp) are measured along the vertical axis and staff
expenditures (S) on the horizontal axis in figure 6.3

FC is the feasibility curve showing the combination of D and S available to the manager. It is also known
as the profit-staff curve. We may also refer this to as discretionary profit curve for the convenience of
understanding. UU1 and UU2 are the indifference curves of the manager which show the combination of
D and S. To begin, as we move along the profit-staff curve from point F upwards, both profits and staff
expenditures increase O till point P* is reached. P* is the profit maximisation point for the firm where
S1P* is the maximum profit levels when OS1 staff expenditures are incurred.

But the equilibrium of the firm takes place when the manager chooses the tangency point E where his
highest possible utility function UU2and the feasibility curve FC touch each other. Here the manager’s
utility is maximised. The discretionary profits ODP (=S2E) are less than the profit maximisation profits
S1P*.

But the staff emoluments are maximised. However, Williamson points out that factors like taxes,
changes in business conditions, etc. by affecting the feasibility curve can shift the optimum tangency
point, like M in the Figure. Similarly, factors like changes in staff emoluments, profits of stockholders,
etc. by changing the shape of the utility function will shift the optimum position.

Q13. List the drawbacks of Williamson’s utility maximisation model.

Ans. The drawbacks of Williamson’s utility maximisation model are as follows:

1. Williamson’s managerial theory does not represent and incorporate the phenomena of
interdependence in Oligopoly.
2. The managerial theory of Williamson does not explain the price and output in the situations
where strong rivalry exists among the oligopolistic firms.
3. The model is not verified by ample evidences.
4. Williamson has lumped together staff and manager’s emoluments in the utility curve. The
mixing up of non- pecuniary benefits of the manager makes the utility function ambiguous.
5. Despite the criticisms, O.E. Williamson in support of his utility-maximisation model has cited
many evidences which are generally consistent with his model.
Thus his theory cannot be empirically ignored and is important as compared with other managerial
theories.
Q14. Describe the firm related goals referred by Cyert and March.

Ans. The firm is supposed to have multiple goals. Cyert and March has referred to five different goals
viz., production goal, inventory goal, sales goal, market share goal, and profit goal.

1. Production Goal:

The production goal represents in large part the demand of those coalition members who are connected
with production. It reflects pressures towards such things as stable employment, ease of scheduling,
development of acceptable cost performance and growth. This goal is related to output decisions.

2. Inventory Goal:

The inventory goal represents the demands of coalition members who are connected with inventory. It
is affected by pressures on the inventory from salesmen and customers. This goal is related to decisions
in output and sales areas.

3. Sales Goal:

The sales goal aims at meeting the demand of coalition members connected with sales, who regard sales
necessary for the stability of the organisation.

4. Market-Share Goal:

The market-share goal is an alternative to the sales goal. It is related to the demands of sales
management of the coalition who are primarily interested in the comparative success of the
organisation and its growth. Like the sales goal, the market-share goal is related to sales decisions.

5. Profit Goal:

The profit goal is in terms of an aspiration level with respect to the money amount of profit. It may also
be in the form of profit share or return on investment. Thus the profit goal is related to pricing and
resource allocation decisions.

While taking the decisions regarding the price, output, and sales strategy the business firms are guided
by the five goals. Cyert and March are of the opinion that although all goals must be satisfied in any
organization, there is an implicit order of priority which is reflected in the way search activity takes
place. If one of the goals is not met and the individual responsible for that is not satisfied, a search will
be made for a means to meet that goal.

Q15. Explain the term ‘satisficing behaviour’.

Ans. Besides side payments, the conflicting goals of the organisation are resolved by subjecting them to
a constant review. This is because ‘aspiration levels’ of coalition members change with experience. In
fact, the aspiration levels change with the process of satisficing. Each person in the organisation has a
satisficing level for each of his goals.

If these levels are reached, they will not seek for more. But if they are not achieved, the aspiration levels
are revised downwards. If they are exceeded, the aspiration levels are raised upwards. In both
situations, the satisfactory levels of performance are changed accordingly.