Economic Analysis for Business Decisions

 You have Rs. 500… what will you do?

 Make choices – Dilemma (individual, society &

country)
 Use resources to satisfy wants but all wants
can’t be satisfied
 Why?
 Two fundamental facts:
 Human being have unlimited wants;
 Means of satisfying these wants are relatively
scarce from the subject matter of economics
 Economics is the branch of
Knowledge that deals with how the
scarce resources can be used to
“Man earns money to
produce valuable goods and services
get material welfare”
and distribute them efficiently
among different classes of people in
the society.

"Political Economy or Economics is a study of men as they

think and move and life in the ordinary business of life. It
examines that part of individual & social action which is
most closely connected with the attainment & with the use
of material requisites of well-being“
• Welfare definition of Economics- Alfred Marshall
 • “Managerial economics is .. the application of economic principles
and methodologies to the decision-making process within the
Douglas firm or organization.”

Pappas • “Managerial economics applies economic theory and methods to

& business and administrative decision-making.”
Hirschey
• “Managerial economics refers to the application of economic
theory and the tools of analysis of decision science to examine
Salvatore how an organisation can achieve its objectives most effectively.”

Howard • “It is the application of economic analysis to business problems; it

Davies has its origin in theoretical microeconomics.”
and Pun-
Lee Lam

4
 Central Problems of
Economy

Allocation of Efficient Use or Fuller

Resources Economic Development or
Utilization of
Growth of Resources
Resources

What to Produce

How to Produce

For Whom to
Produce
 What?
How to How much?
distribute?

For whom? Goods and What

services combination?

How
How?
efficiently? When?
Unlimited wants
• with the development of education, knowledge, scientific advancement
and economic growth wants go on increasing

Different priorities
• All wants are not equally important. Some are more important and some
are less

Limited means
• the existing supply of resources is inadequate in relation to the known
desires of individuals

Means having alternative uses

• This gives rise to the problem of choice. It means that we have to
choose, which wants should be satisfied and in what quantity.
In economics, a model is
a theoretical construct that
represents economic processes by
a set of variables and a set
of logical and/or quantitative
relationships between them.

The economic models a simplified

framework designed to illustrate
complex processes, often but not
always using mathematical
techniques.
Stochastic models: Random process Models (Based on statistics &
Hypothesis Formulation)

Non- Stochastic models: may be purely qualitative (for example,

models involved in some aspect of social choice theory) or
quantitative (involving rationalization of financial variables, for
example, specific forms of functional relationships between
variables).

Qualitative models: Although almost all economic models involve

some form of mathematical or quantitative analysis, qualitative
models are occasionally used. Like qualitative scenario planning in
which possible future events are played out. Another example is
non-numerical decision tree analysis. Qualitative models often
suffer from lack of precision.
Quantitative modeling: At a more practical level, quantitative modeling
is applied to many areas of economics and several methodologies have
evolved more or less independently of each other.

Accounting model : is based on the premise that for every credit there
is a debit. More symbolically, an accounting model expresses some
principle of conservation in the form
• algebraic sum of inflows = sinks − sources

Aggregate Models: Macroeconomics needs to deal with aggregate

quantities such as output, the price level, the interest rate and so on.

• However, for the most part, these models are computationally much
harder to deal with and harder to use as tools for qualitative analysis.
• For this reason, macroeconomic models usually lump together
different variables into a single quantity such as output or price.
Moreover, quantitative relationships between these aggregate
variables are often parts of important macroeconomic theories
 Production
 The use of economic resources in the creation of goods
and services for the satisfaction of human wants.
 Consumption

 The using up of goods and services by consumer

purchasing or in the production of other goods.
 Employment

 The use of economic resources in production;

engagement in activity
 Income Generation

 The production of maximum amount an individual can

spend during a period without being any worse off.
 Household
 The basic consuming unit.

 Firm
 The basic producing unit.
 Flow
 A quantity measured over a particular period of time.
 Stock
 A quantity measured as of a given point in time.

The concepts of stock and flow measurements

are essential in understanding the economic variables
of wealth and income.

◦ Wealth
 Anything of valued owned. It is a stock since it is
what is owned at a particular time.
◦ Income
 The rate at which we earn money. It is a flow since
income that is saved, increases the stock of wealth.
The Circular Flow of the Production Process
 RAW MATERIALS

RAW MATERIAL FIRM INTERMEDIATE GOOD

FIRM

CONSUMERS

INTERMEDIATE
GOODS
FINAL GOODS

FINAL GOOD FIRM

 RAW MATERIAL FIRM
RESOURCES

INTERMEDIATE GOOD
HOUSEHOLDS RESOURCES
FIRM

RESOURCES FINAL GOOD FIRM

 The Circular Flow of Goods and Income
Among Producers & Households
RESOURCES RAW MATERIAL
FIRM

MONEY PAYMENT FOR RESOURCES

RESOURCES

MONEY PAYMENT FOR RESOURCES

HOUSEHOLDS INTERMEDIATE
GOOD FIRM
RESOURCES

MONEY PAYMENT FOR RESOURCES

MONEY PAYMENT FOR PURCHASE OF FINAL

GOODS

FINAL GOOD FIRM

FINAL GOODS
 INCOME FLOW OF WAGES, INTERESTS,
RENTS

HOUSEHOLDS PRODUCING UNITS

PURCHASES OF GOODS AND

SERVICES
 MONEY PAYMENTS FOR
RAW MATERIALS

RAW MATERIALS INTERMEDIATE

FIRM GOOD FIRM

MONEY PAYMENTS FOR

INTERMEDIATE GOODS

FINAL GOOD FIRM

MONEY PAYMENTS FOR

HOUSEHOLDS
FINAL GOODS
Circular Flow of Physical Goods and Money Income

Goods and Services

Factors of Production
(land, labor, capital, entrepreneur)

Household Business
Sector Sector

Payments of Factors
(rent, wages, interest, profit)

Payment of Purchase
of goods and services.
The goods, resources, and money payments will flow
as long as households continue to consume, and as
long as firms continue to produce.

That since goods and resources flow in exchange for

payments, the rate of payments flow will in the end be
the same. Money is the inducing factor, and the pillar
of the price system. Without it, there is no price
system.
Outflows (factors that decrease the level of
economic activity)
1. Savings
2. Taxes
3. Imports

Inflows (factors that increase the level of

economic activity)
1. Investment
2. Government Spending
3. Exports
 Outflows are difficult to control because they are
dependent on income. When income increases, we
expect savings, taxes, and imports to increase.

• Inflows are easier to manipulate. The proper use of

policy enables the government to encourage exports and
investments and to increase its expenditures when it
desires to expand the flow of economic activity.
Monetary policy
1. Affects the savings and investment.

Fiscal policy
1. Controls taxes and government
expenditures.

Trade policy
1. Affects a country’s exports and
imports.
 An understanding of the reason for the
existence of firms, their specific role in the
economy, and their objective provides a
background for that theory.

In order to earn profits, the firms organizes the

factors of production to produce goods and
services that will meet the demands of individual
firms and other firms
Firm exists as organization because the total cost of producing any rate
of output is lower than if the firm did not exist

Reasons:

• Cost of obtaining information on prices, cost of negotiating and

concluding contracts for each step of production process would be
very burdensome.
Firms hire labor for long periods of time under agreements that specify
a wage rate per hour or day.
• That is, one general contract between owners and workers.
• The two parties do not negotiate the terms of new contract for new
assignments.
• The saving of transaction cost is beneficial for both the parties.
Some government interference in the marketplace applies to
transactions among firms rather than within firms

For e.g., sales taxes apply to transaction between firms.

In some states, a construction company will have to pay sales tax

on cabinets purchased from Independent cabinetmaker.

By hiring that person, this tax is avoided and cost of producing

output is reduced.

Given that production cost are reduced by organizing production

factors, why won‟t this process continue until there is just one large
firm
At least two reasons which may be termed as Diminishing returns to
management

The cost of organizing transactions within the firm tends to rise as the
firm gets larger. At some point, these internal transaction costs will
equal the cost of transacting in the market. At this point, firm cease to
grow.

• For e.g. Automobile manufacturer purchasing tires from Goodyear,

Michelin and other rather than cost of developing new facility and
new managerial skills

Limitation of an Entrepreneur's Organizational skill. Resources within

the company may not be efficiently allocated if the firm‟s size exceeds
the manager‟s ability to control the operations.

• To overcome this problem, Division called as profit centers

 For an optimal
Problem – For which
Decision, Goals & Traditionally -- Profit
period, this Year?
objectives needs to Maximization
Next Five Years?
be established

Expenditure for R & D, Capital

Maximize firm‟s value by
Equipments & Major Marketing
maximizing profit in each time
Programs are examples that
period
reduce profits initially but
significantly increase future profits

Value of a firm =
Where ∏t is profit in time period t, and r is an appropriate discount
rate used to reduce future profits to their present value.

Value of a firm

• Price for which it can be sold

• Equal to net present value of expected future profit

Most of the large firms in market economies are corporations

where ownership is spread among literally thousands of
individuals, each of whom owns shares of stocks that represent the
ownership.

It is now common to hear the decision making aligned to

maximizing shareholders value which is also called as wealth
maximization
In economics, satisficing is a behaviour which attempts to
achieve at least some minimum level of a particular
variable, but which does not necessarily maximize its
value.

The most common application of the concept in economics

is in the behavioural theory of the firm, which, unlike
traditional accounts, postulates that producers treat profit
not as a goal to be maximized, but as a constraint.

Under these theories, a critical level of profit must be

achieved by firms; thereafter, priority is attached to the
attainment of other goals.
The goals set are flexible and revisable from time to time
depending on past attainments, conditions prevailing in the
economy and changes in their aspirations of the various groups
within the firm.

The actions of the firm are guided by limited or bounded

rationality. The firms management after considering all possible
alternatives decides the order of preferences for different goals.

The management in a modern corporate firm have limited

information, limited time and limited computing ability. Therefore,
the management examines a few alternatives and chooses the best
out of them.

This is the satisficing behaviour of the firm which is rational.

 Biggest challenge before modern businesses is lack
of full information and uncertainty about future

the objective of maximizing either profit, or sales, or

growth is not possible.

they act as constraints to rational decision making

the firm has to operate under "bounded rationality"

can only aim at achieving a satisfactory level of profit,

sales and growth
Apart from dealing with inadequate information and
uncertainty, businesses also have to satisfy a variety of
stakeholders, who have different and oft conflicting
goals

„Satisficing behaviour‟ aims at satisfying all

stakeholders.

Managers form an Aspiration level on basis of past

experience, past performance of the firm, performance
of other similar firms, and future expectations
 Cyert and March
propose that
Simon‟s satisficing
businesses have to
model says that a firm
satisfy a variety of
has to operate under
stakeholders, who
"bounded rationality"
have different and oft
and can only aim at
conflicting goals;
achieving a
hence a firm has to
satisfactory level of
aim at a multi
profit, sales and
dimensional goal and
growth
exhibit a „satisficing
behaviour‟.
Optimization means solving problems in which one seeks
to minimize or maximize areal function by systematically

Economics relies so heavily on optimization that some

economists define their field as the study of optimization
under constraints or optimization under scarcity.

Modern optimization theory overlaps with game theory

and the study of (economic) equilibrium, as well as
traditional optimization theory.
We can describe moral hazard problems as a principal-agent
relationship

• This refers to situations where there is a party (the agent) that

works on behalf of another party (the principal)
Principal-agent relationships feature:

• Conflicting objectives between principal and agent

Examples:
• Principal and agent gain from working together
• Principal cannot fully observe or verify agent‟s actions
• Manager and worker (manager is principal)
• Shareholder and manager (shareholder is principal)
• Government and regulated firm (government is principal) 38
 One problem in assuming that
businesses set price and How do the owners of a
output to maximise profits is business know that managers
that decision-taking where making the key day-to-day
there is a break up between decisions are operating to
ownership and control can be maximise shareholder value?
difficult to monitor.

This lack of information is known as

The decisions and the
the principal-agent problem. In other
performance of the agent
words, one person, the principal,
are impossible and or
hires an agent (e.g. a sales or finance
expensive to monitor and
manager) to perform tasks on his
the incentives of the agent
behalf but he cannot ensure that the
may differ from those of
agent performs them in precisely the
the principal.
way the principal would like.
Accountants measure a firm‟s profit to ensure that the
firm pays the correct amount of tax and to show it
investors how their funds are being used.

Profit equals total revenue minus total cost.

Accountants use Internal Revenue Service rules based on

standards established by the Financial Accounting
Standards Board to calculate a firm‟s depreciation cost.
 Economists measure a
Economic profit is equal
firm‟s profit to enable
to total revenue minus
them to predict the firm‟s
total cost, with total cost
decisions, and the goal of
measured as the
these decisions in to
opportunity cost of
maximize economic
production.
profit.
A firm‟s opportunity cost of production is the
value of the best alternative use of the
resources that a firm uses in production.

A firm‟s opportunity cost of production is the

sum of the cost of using resources

• Bought in the market

• Owned by the firm
• Supplied by the firm's owner
Imagine that two years after On New Year‟s Day, after
receiving your college deciding to be your own
degree your annual salary as boss, you quit your job,
an assistant store manager evict your tenants, and use
is $28,000, you own a your financial assets to
building that rents for establish a furniture shop.
$10,000 yearly, and your At the end of the year, your
financial assets generate books tell the following
$3,000 per year in interest. story:
 Total Sales
Revenue $130,000
 Cost of RM
$85,000
 Employees’
wages 20,000
 Utilities 5,000
 Taxes 5,000
 Advertising
expenses 10,000
 Total (Explicit)
Costs –
125,000

 (subtract from revenue)

 “Congratulations,” your bookkeeper pipes up, “you
 “Hold it just a moment,” you say, “I have
studied economics. You forgot to subtract my implicit
costs. Being in this business caused me to lose as income

 Salary
–28,000

 Rent
–10,000

 Interest
–3,000

 Total Implicit
Costs –41,000

 “Therefore, I’ve had an economic profit that’s negative,

a loss of –36,000
Finance for investment:

• Retained profits are source of finance for companies

undertaking investment projects. The alternatives such
as issuing new shares (equity) or bonds may not be
attractive depending on the state of the financial markets
especially during credit crunch.

Market Entry:

• Rising profits send signals to other producers within a

market. When the existing firms are earning supernormal
profits, this signals that profitable entry may be possible.
In contestable markets, we would see a rise in market
supply and lower prices.
Demand for factor resources:

• Scarce factor resources tend to flow where the expected rate

of return or profit is highest. In an industry where demand is
strong, more land, labour and capital are then committed to
that sector. In a flexible labour market, a fall in demand can
quickly lead to a reduction in investment and cut-backs in
labour demand.

Signals about the health of the economy:

• The profits made by businesses throughout the economy

provide important signals about the health of the macro
economy. Rising profits might reflect improvements in
supply-side performance (e.g. higher productivity or lower
costs through innovation). Strong profits are also the result
of high levels of demand from domestic and overseas
markets.
The Wealth of Nations (1776).

There is a benevolent deity who administers the world in such a way as to

maximize human happiness.

In order to do this he has created humans with a nature that leads them
to act in a certain way.

The world as we know it is pretty much perfect, and everyone is about

equally happy. In particular, the rich are no happier than the poor.
Although this means we should all be happy with our lot in life, our
nature (which, remember, was created by God for the purpose of
maximizing happiness) leads us to think that we would be happier if we
were wealthier.
This is a good thing, because it leads us to struggle to become wealthier,
thus increasing the sum total of human happiness via the mechanisms of
exchange and division of labor.
 Economics can be understood as a process
involving acting agents
There is no explicit agreement between the acting
agents

The process is not intentional

The agents' aims are not coordinated nor identical

with the actual outcome
The process should work even without the agents
having any knowledge of it
In order for this economic process to work, the
following pre-conditions must be met:
• contracts must be enforceable
• people must have good access to information
• the rule of law must hold

The result of this economic

process: The “Free Market”
consumers seek the lowest price (by making their excess or insufficient
demand known through market prices, consumers “direct” entrepreneurs'
investment money to the most profitable industry)

Producers seek the highest rate of profit (by producing the goods most
highly valued by consumers, overall economic well-being is increased)

• Why is this the best system?

• What are the alternatives?

We could get people to cooperate with our needs by appealing to their

benevolence and goodwill (aside from being utopian, this would require
people to be servile)
We could devise a system of forced economic interactions (a command economy)
to ensure that everyone‟s needs are met

Instead, we construct a system wherein we appeal to each other‟s self-interest in

a series of “exchanges”. In proposing an exchange, we attempt to show each
other that what we can do, or what we have, than can be of use to the other

This is why so much of a person's self-esteem is bound up in their job: a well-

paid job is supposed to be a sign that others value our contribution and find it
worth exchanging their own resources for
 By interjecting competition,
Solves Government Failure:
efficient delivery of public
Government sometimes
goods by private
provides for an inefficient
entrepreneurs, via the free
allocations of public goods
market, is possible

Supply-side vs. Demand-side

Regulated free markets:
economics

The role of fiscal and Economic, consumer, and

economic policy environmental regulation
Thank you