Introduction to

Managerial Economics
UNIT 3 BASIC CONCEPTS & TECHNIQUES
Objectives

After studying this unit, you should be able to:

 identify a wide range of techniques used in managerial economics;
 apply the techniques to understand the meaning of the results;
 identify the strengths and weaknesses of the different meth.

Structure

3.1 Introduction
3.2 Opportunity Set
3.3 Variables and Constants
3.4 Derivatives
3.5 Partial Derivatives
3.6 Optimization Concept
3.7 Regression Analysis
3.8 Specifying the Regression Equation
3.9 Estimating the Regression Equation
3.10 Decision Under Risk
3.11 Uncertainty Analysis and Decision Making
3.12 Role of Managerial Economist
3.13 Summary
3.14 Self-Assessment Questions
3.15 Further Readings

3.1 INTRODUCTION
The manager needs various techniques to assist and help him in making
decisions that will ultimately maximize the value of the firm. These
techniques and tools are quantitative in nature. The introduction of some
commonly used tools used in managerial decision making becomes
imperative.

In this unit we are going to discuss some basic techniques which would be
helpful in understanding the concept of managerial economics, in turn
helping us to apply these techniques as and when required.

3.2 OPPORTUNITY SET

A set is a collection of distinct or well defined objects like (5, 6, 7) or (a, b,
c). For example listing of all residents of Delhi or all animals in a zoo is
difficult. Thus a set is also formed by developing a criterion for membership.
For example the set of all positive numbers between 1 and 10 or set of all
points lying on the line x + y = 4.

In managerial economics the need is to define an opportunity set of a decision

maker, i.e., the set of alternative actions which are feasible. For example, the
42 opportunity set of a consumer is the set of all combinations of goods which
the consumer can buy with his given income. Given the consumer’s budget Basic Concepts &
and prices of all goods, the opportunity set is well defined, and we can find Techniques
out whether the consumers can buy that combination of goods. If a person
consumes only two goods (x, y), whose prices are Rs. 5 and Rs. 4 per unit,
and his income is Rs. 100, then the opportunity set is as is shown in Figure
3.1.

Figure 3.1: Opportunity Set

If the consumer spends all his income on X, he can buy 20 units of X with no
Y (B). or if he spends all on good Y, then he buys 25 units of Y and no X
(A). All other alternatives of spending Rs. 100 will lie on the line AB. Hence
the area OAB constitutes the consumer's opportunity set.

3.3 VARIABLES AND CONSTANTS

Variables are a measure which change and can take a set of possible values
within a given problem. A constant or parameter is a quantity which does not
change in a given problem. For example, consider Y=a+bX; here, a and b are
constants and X and Y are variables. X is the independent variable or
exogenous variable while Y is the dependent or endogenous variable. The
value of X will be given from outside the system, while values of Y will be
determined from within the system (by the equation). X can assume different
values and this will cause Y to assume different values also.

We can show the relationship between two variables Q and P by a function,

such that for every value of P there is only one value of Q. In this case of
function is Q = Q(P). These are the basic building blocks of economic
models. The function Q=Q(P) is a demand function and its graph which
price on one and quantity on the other axis will give a demand curve. P, is
the argument of the function or the independent variable and Q is the
dependent’ variable. It indicates the cause-effect relationship between
variables. (P is the cause variable, while Q is the effect variable).
43
Introduction to A function can be represented by means of a table or graph.
Managerial Economics
Figure 3.2: Linear Function

Figure 3.3: Quadratic Function

Figure 3.4: Quadratic Function

44
 Figure 3.5: Cubic Function Basic Concepts &
Techniques

Five key functions of economics are represented graphically:

1. Demand (Linear)

Figure 3.6

2. Total Revenue (Quadratic)

Figure 3.7

45
Introduction to 3. Production (Short run) (Cubic)
Managerial Economics
Figure 3.8

4. Cost (Short Run) (Quadratic)

Figure 3.9

5. Profit (Short run) (Quadratic)

Figure 3.10

46
 Basic Concepts &
3.4 DERIVATIVES Techniques

The “slope” in mathematical use is the concept of ‘marginalism’ in economic

use. Thus if Y=Y(x), dy/dx stands for change in Y as result of one unit
change in X, i.e. marginal y of x. This slope or marginal function has
enormous use in managerial economics. Thus,

Marginal demand of price, when Q=Q(P)

Marginal sales of advertisement, when S=S(A)

Marginal revenue of output, when R=R(Q)

Marginal cost of output, when C=C(Q)

In case of ‘averages’

When marginal concept is divided by corresponding average concept, we get

the measure of economic concept of elasticity.

Thus, such elasticities measure the proportion of change, e.g., if the

percentage change in demand is greater than the percentage change in price,
then

∗ 1

47
Introduction to
Managerial Economics ∗ 1

∗ 1 .

Elasticity is discussed in detail in Block 2.

The standard rules of differentiation in calculus are given in Appendix.

3.5 PARTIAL DERIVATIVES

In managerial economics, usually a function of several independent variables
is encountered instead of a single variable case shown above. For example, a
consumer’s demand for a product depends on the price of the product, price
of other related goods, income, tastes, etc. When the price changes, the effect
on quantity demanded of the goods can be analyzed only when all other
variables are kept constant. The functional relationship that is obtained
between the quantity demanded of a product and its own price is called a
Partial Function (a function of one variable when all other variables are kept
constant). The derivatives of the partial functions are known as partial
derivatives of the original function and is shown as / or or f’(x).
The conventional symbol used in maths for the partial derivative is delta, .
Partial derivatives are functions of all variables entering into the original
function f(x).

Examples:

(i) If ;

Then 2

And 2 2

/ / /
(ii) If √

/ /

/
/ /
Then /

/
/ /
And /

48
(iii) If 4x 3xy 5y Basic Concepts &
Techniques

Then 8 3

Then 3 10

Remember the derivatives of a constant is 0, i.e / of 5y is 0. Thus in

the above equation while calculating / we hold x constant and hence
/ of 4x is 0. This gives / to be 8x+3y; and / to be 3x+10y.

, , , , are called first order partial derivatives.

The second order partial derivatives indicate that the function has been
differentiated partially twice with respect to a given variable, all other
variables being held constant. These are shown (in case of function Z=f(x,y)
by or and . Thus shows the rate of change of first order partial
derivatives fx with respect to x and y held constant.

Similarly is the second order partial derivatives of the function with

respect to y with x held constant.

3.6 OPTIMISATION CONCEPT

Optimisation is the act of choosing the best alternative out of the available
ones. It describes how decisions or choices among alternatives are taken or
should be made. All such optimisation problems have 3 elements:

a) Decision Variables: These are variables whose optimal values have

to be determined. For example, a production manager wants to know
at what level to set output in order to achieve maximum profit or
maximum sales revenue. Here output is the decision or choice
variable. Similarly labour, machine, time and raw materials are choice
variables if a works manager wants to know what amount of these are
to be used so as to produce a given output level at minimum cost. The
quantity of any choice variable must be measurable (20kg, 5
labourers, 10 hours, etc.)
b) The Objective Function: It is a mathematical relationship between
the choice variables and some variables whose values are to be
maximized or minimized. For example, the objective function could
relate profit to level of output or cost to amount of labour, machine,
time, raw materials, etc. in the above example.
c) The Feasible Set: The available set of alternatives is called a feasible
set.

A solution to an optimization problem is that set of values of the choice

variables which is in the feasible set and which yields maximum or minimum
of the objective function over the feasible set.
49
Introduction to Unconstrained Optimization Technique
Managerial Economics
For unconstrained optimization problem involving single independent
variable, we need to satisfy some “conditions”. In economics, the necessary
(first order) condition is called the equilibrium condition and sufficient
(second order) condition is called the stability condition (continuation of state
of equilibrium). There may be equilibrium but it may not be stable. Thus first
order condition does not guarantee second order condition. This is
summarized in Table 3.1.

Table 3.1: Optimization Conditions

Order Conditions Optimization Unconstrained

First order Necessary Maximization Maximization

Conditions
0 0

Second order Sufficient y y

0 0
Conditions x x

Y=y(x)
(assumed)

Some economic uses f these conditions are discussed below. Given a firm’s
demand function, P=45 – 0.5Q and the average function, AC=Q -8Q + 57 +
2/Q, we have to find the level of output Q which
a) Maximizes total revenue
b) Maximizes profit

Solution
a) Since demand function is P=45-0.5Q the total revenue function will be,
TR=PQ = (45-0.5Q) Q=45 – 0.5 Q
To maximize TR, we find the derivative and set it to 0 (the first order or
necessary condition)

Now, 45 2 0.5
45 0
∴ 45

The second order condition (sufficient conditions) needs to be

negative.

Since 45

∴ 1
50
 which is negative. Hence total revenue is maximized when output is 45 Basic Concepts &
Techniques
units.
b) From profit function

Q 8Q 57 2/Q Q Q 8Q 57Q 2
45 0.5
45 0.5Q
After substituting TR and TC, we get
45 0.5Q Q 8Q 57Q 2

∴ 45 3Q 16Q 57

3Q 15Q 12

Now set 0

3Q 15Q 12 0
dividing by -3
Q 5Q 4 0
or (Q-4) (Q-1)=0
 4 1

Constrained Optimisation Technique

There are many situations where the objective function has to be maximized
or minimized subject to certain constraints present in the problem. Thus a
consumer may be maximizing utility subject to the income constraint.

The techniques used to analyze such problems are based on that used for
unconstrained problems. The constrained problem is converted into
unconstrained one with the help of Lagrange Multiplier Technique and then
the latter is solved. In this technique, the objective function and constraint is
combined in one expression (Lag range expression) such that the constrained
maximization or minimization problems are reduced to unconstrained ones.

For example,

Maximize 8x 20
Subject to 2
(function of single independent variable)

The objective function (function to be optimized) is 8x

20, plotted on graph: 51
Introduction to Figure 3.11: Objective Function
Managerial Economics

The objective function 8x 20 can be written as

4 36

Now 4 has an unconstrained maximum value of zero at 4.

However, our objective functions is 4 36, and hence will have an
unconstrained maximum of 36 (at x=4). This is so for the first derivative test.

The second derivative test gives -2 since 2x

8; 2

Thus both test give x=4 as the above of the variable. This is the value at
which the objective function attains unconstrained maximum. However, the
problem has a constraint x=2. Thus we have to consider the function only up
to value of x=2 (graph) starting from x 2. The maximum value of the
function is then 32 which occurs when x=2. Thus the constrained maximum
of the function 4 36 with constraint x=2 would occur at x=2
would occur at x=2 and not x=4.

The Lagrange expression for constrained maximization is formed as follows

4 36 with constraint x=2 and x-2=0.

Combining, we get the Lagrange expression 4 36

 x 2 .

Adding objective function and product of  (Lagrange Multiplier) and the

constraint function x-2=0. Now L is a function of x and.

We find

and set them to 0



2 4  0


52 2 0

The last equation gives x=2. Hence the constrained maximum occurs at x=2. Basic Concepts &
Techniques

In this problem =2(x-4) = 2(2-4) = -4.

When applying Lagrange technique to solve economic decision problem, λ

will have an economic significance. For example in consumer’s utility
maximizing problem (where quantities of commodities are choice problems),
λ will be the marginal utility of money income. In producer’s cost
minimization profit, λ will be the marginal cost of production. In complex
problems, as many λ’s as many there are constraints have to be used.

The problem with two independent variables can also be solved with
Lagrangian technique. To find out whether the optimized value is maximum
or minimum however, requires second derivative test as well as use of some
more determinants not to be discussed here

Activity 1

a) Draw graph of the following functions:

i) 10 0.4
ii) 15 2 4P
iii) 100 0.8

b) A firm’s fixed costs are `6000.00 regardless of output (they do not

change when output changes), variable cost is `5 per unit of output
variable cost is dependent on output). Total cost = fixed costs + variable
costs. The selling price of the goods is `100 per unit. Let Q be the output.
State the

i) Firms fixed cost function

ii) Variable cost function
iii) Total cost function
iv) Total revenue function

c) Maximize 10 2y
Subject to x+y=12

d) Maximize 737 8Q 14A QA 4a 20Q

Subject to 2Q+A=2.

Answers:

c) X=7, y=5, =-50

d) Q=0.52, A=0.96, 1= -6.36

3.7 REGRESSION ANALYSIS

A manager must often determine the total cost of producing various levels of
output. The relation between total cost (C) and quantity (Q) is,
53
Introduction to C = a + bQ + cQ2 + dQ3
Managerial Economics
Where a, b, c and d are parameters of the equation. Parameters are
coefficients in an equation that determine the exact mathematical relation
among the variables in the equation. If the numerical values of parameters are
determined, the manager knows the quantitative relation between output and
total cost. If the value of parameters of cost equation are calculated to be
a=1262, b=1, c=–0.03 and d=0.005, the equation becomes,

C = 1262 + 1Q –0.03Q2 + 0.005Q3

This equation can be used to compute the total cost of producing various
levels of output. If, for example, the manager wishes to produce 30 units of
output, the total cost can be calculated as

C = 1262 + 30 –0.03(30)2 + 0.005(30)3 = Rs. 1400.

Thus, in order for the cost function to be useful for decision making, the
manager must know the numerical value of the parameters.

The values of the parameters are often obtained by using a technique called
regression analysis. It determines the mathematical relation between a
dependent variable and one or more explanatory variables.

 Dependent variable: The variable whose variation is to be explained.

 Explanatory variables: The variables that are thought to cause the
dependent variable to take on different values

In the simple regression model, the dependent variable Y is related to only

one explanatory variable X, and the relation between X and Y is linear

Y=a+bX

Figure 3.12: Relation between sales and advertising expenditure

Expenses on advertising per month (crores)

54
This is the equation for a straight line, with X plotted along the horizontal Basic Concepts &
axis and Y along the vertical axis. The parameter a is called the intercept Techniques
parameter because it gives the value of Y at the point where the regression
line crosses the Y-axis. (X is equal to zero at this point). The parameter b is
called the slope parameter because it gives the slope of the regression line.
The slope of a line measures the rate of change in Y as X changes (DY/DX);
it is therefore the change in Y per unit change in X.

Intercept parameter: The parameter that gives the value of Y at the point
where the regression line crosses the Y-axis.

Slope parameter: The slope of the regression line, b = ∆Y/∆X, or the change
in Y associated with a one-unit change in X.

Y and X are linearly related in a regression model. The effect of change in X

on the value of Y is constant. A one-unit change in X causes Y to change by
a constant b units.

The figure shows the true relation between sales and advertising
expenditures. If a firm chooses to spend nothing on A, its sales are expected
to be `100 crores per month. If the firm spends `30 crores on A then it can
expect sales of `250 crores (=100 + 5 × 30). ∆S/∆A = 5, i.e., for every 1 unit
increase on advertising, the firm can expect a 5 unit increase in sales.
Regression involves identifying and calculating specific relationships
between the independent variables and the dependent variable. It involves a
number of stages which are described in another section.

Activity 2

a) The slope parameter is …………………… and the intercept parameter is

………………. in the equation R=a+bW.

b) In Figure 3.12, what will be the monthly sales of the firm, if the
advertising expenditure is increased from `30 crores to `40 crores per
month?
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3.8 SPECIFYING THE REGRESSION EQUATION

The first thing that the organisation carrying out the regression analysis needs
to do is to determine the range of variables which may affect demand for the
product concerned. For example, the own price of a good might reasonably
be expected to be a determinant of demand for most products, as would any
advertising being done by the firm. The question of whether there are any
substitute or complementary goods which need to be taken into account could
then be raised. In the case of, an expensive consumer durable good, the cost
and availability of credit might be a consideration. Any special ‘other’ factors
affecting demand could then be identified and so on. This choice of variables
has to be made before it is possible to progress to the next stage.
55
Introduction to Data Collection
Managerial Economics
Once the relevant variables have been identified, quantitative data need to be
assembled for each of them. This will be easier for some of the variables than
for others. In dealing with an established product, for example, the firm might
reasonably be expected to have access to a range of information regarding the
variables which it controls such as own price and advertising. What may be
more difficult to obtain, however, is information about competitors’ products.
On this front, price data can be obtained through observing retail prices, as
this information by definition is in the public domain and cannot be hidden.
This requires continued market observation, perhaps over a long period of
time. Likewise, information about product design changes can be obtained by
buying the competitors’ product(s), but this may be expensive if there are
many on the market. Confidential, commercially sensitive information such
as actual advertising expenditure by competitors and their proposed new
products present much more difficult problems in terms of access and may
have to be left out of the process altogether. Data on levels of disposable
income, population variables, interest rates and credit availability are easier
to obtain, for example from government statistics, but other variables are
more problematic. How can things like expectations and tastes be measured
for instance? In these cases the available data, perhaps resulting from market
surveys, may be qualitative rather than quantitative. Some means of
conversion need to be found if they are to be included in the regression
analysis at all. These are the things which the decision maker needs to keep in
mind while collecting and selecting data on the relevant variables. Once the
first two steps have been completed, the next stage is to specify the likely
form of the regression equation. There are two main forms which are used in
practice -the linear demand function and the non-linear or power function.
Both treat the demand for the product as the dependent variable, while the
independent variables are those which have previously been identified as
having an effect on demand. If, for example, the firm had decided that the
only variables affecting demand for a particular product with its own price
and advertising levels then the linear demand function would be
written as:

Q = a + bP + cA

Alternatively, under these conditions the exponential (power) function would

be written as:

In each case, the ‘a’ term represents the intercept of the-line drawn from the
equation with the vertical axis. The ‘b’ and ‘c’ terms represent the regression
coefficients with respect to own price and advertising respectively. These
show the impact of each of these variables on product demand. Once they
have been estimated it is possible to predict the level of demand for any set of
values of the independent variables simply by substituting them into the
equation.
56
The exponential form of the equation has the advantage that it can be Basic Concepts &
rewritten to give direct estimates of the respective elasticities of demand for Techniques
the independent variables. This is done by taking the log-linear form of the
equation which in this case would be:

log Q = log a + b log P + c log A

Where ‘b’ and ‘c’ are the own price and advertising elasticities of demand
respectively. This is a much easier approach than calculating elasticities
through use of the linear form which involves using the equation:

to calculate the elasticities in each case. In this case values of P and Q need to
be obtained from the data set. Usually average values are substituted in the
above equation to estimate elasticities. This idea will be explored in greater
detail in Block 2.

Which of the two forms of equation is chosen depends upon the expected
relationship between the variables being included. In practice, however, the
actual relationship between them may not be known in advance. In this case,
the decision maker may experiment with both forms of equation in order to
find the one which most closely fits the data.

Activity 3

1. What are the things which the decision maker needs to keep in mind
while collecting and selecting data on the relevant variables?

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

2. Show that estimated coefficients using a log-linear technique are

estimates of elasticity with respect to the relevant variable.

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3.9 ESTIMATING THE REGRESSION

EQUATION
Consider a firm with a fixed capital stock that has been rented under a long-
term lease for ` 100 per production period. The other input in the firm’s
production process is labour, which can be increased or decreased quickly
depending on the firm’s needs. In this case, the cost of the capital input
(`100) is fixed and the cost of labour is variable. The manager of the firm 57
Introduction to wants to know the relationship between output and cost, that is, the firm’s
Managerial Economics total cost function. This would allow the manager to predict the cost of any
specified rate of output for the next production period.

Specifically, the manager is interested in estimating the coefficients ‘a’ and

‘b’ of the function
Y = a + bX

where the dependent variable Y is total cost and the independent variable X is
total output. If this function is plotted on a graph, the parameter ‘a’ would be
the vertical intercept (i.e., the point where the function intersects the vertical
axis) and ‘b’ would be the slope of the function. Recall that the slope of a
total function is the marginal function. As Y = a + bX is the total cost
function, the slope, ‘b’, is marginal cost or the change in total cost per unit
change in output.

Assume that data on cost and output have been collected for each of seven
production periods and are reported in Table 3.2. Note that there is a cost of
Rs. 100 associated with an output rate of zero. This represents the fixed cost
of the capital input, which must be paid regardless of the rate of output.
These data are shown as points in Figure 3.1. They suggest a definite upward
trend, but they do not trace out a straight line. The problem is to determine
the line that best represents the overall relationship between Y and X. One
approach would simply be to “eyeball” a line through these data in a way that
the data points were about equally spaced on both sides of the line. The
coefficient ‘a’ would be found by extending that line to the vertical axis and
reading the Y-coordinate at that point. The slope, ‘b’, would be found by
taking any two points on the line, { , } and
{ , } and using the slope formula

Although this approach could be used, the method is quite imprecise and can
be employed only when there is just one independent variable. What if
production cost depends on both the rate of output and the size of the plant?
To plot the data for these three variables (total cost, output, and plant size)
would require a three dimensional diagram; it would be nearly impossible to
eyeball the relationship in this case. The addition of another independent
variable, say average skill levels of the employees, would place the data set in
the fourth dimension, where any graphic approach is hopeless.

Table 3.2: Hypothetical Data on Total Cost and Total Output

Production period Total Cost ( )` Total Output (

100 0
150 5
160 8
240 10
280 15
370 23
410 25
58
There is a better way. Statisticians have demonstrated that the best estimate Basic Concepts &
of the coefficients of a linear function is to fit the line through the data points Techniques
so that the sum of squared vertical distances from each point to the line is
minimized. This technique is called ordinary least-squares regression (OLS)
estimation and a number of statistical packages, including excel. Based on the
output and cost data in Table 3.1, the least-squares regression equation will
be shown to be

87.08 12.21X

This equation is plotted in Figure 3.13. Note that the data points fall about
equally on both sides of the line. Consider an output rate of 5. As shown in
Table 3.2, the actual cost associated with this output level is 150. The value
predicted by the regression equation, referred to as , is 148.13. That is, =
87.08 + 12.21(5) =148.13. The deviation of the actual Y value from the
predicted value (i.e., the vertical distance of the point from the line), is
referred to as the residual or the prediction error.

Figure 3.13: Total Cost, Total Output and Estimated

Regression Equation

There are many values that might be selected as estimators of ‘a’ and ‘b’, but
only one of those sets, defines a line that minimizes the sum of squared
deviations [i.e., that minimizes  ]. The equations for computing
the least-squares estimators and are




and

When and ̅ are the means of the Y and X variables.

Using the basic cost of output data and the example, the necessary
calculations are shown in Table 3.3. Substituting the appropriate values into
the following equations, the estimates of and are computed to be


12.21


237.14 12.21 12.29 87.08 59

Introduction to Table 3.3: Summary calculation for computing the Estimates and
Managerial Economics
Cost ( Output ( ( (

100 0 137.14 12.29 151.04 1,685.45

150 5 87.14 7.29 53.14 635.25

160 8 77.14 4.29 18.40 330.93

240 10 002.86 2.29 5.24 6.55

230 15 7.14 2.71 7.34 19.35

370 23 132.86 10.71 114.70 1,422.93

410 25 172.86 12.71 161.54 2,197.05

237.14 12.29  

=511.40 =6,245.71

Thus the estimated equation for the total cost function is

87.08 12.2

The estimate of the coefficient a is 87.08. This is the vertical intercept of the
regression line. In the context of this example, = 87.08 is an estimate of
fixed cost. Note that this estimate is subject to error because it is known that
the actual fixed cost is ` 100. The value of is an estimate of the change in
total cost for a one-unit change in output (i.e., marginal cost). The value of ,
` 12.21, means that, on an average, a one-unit change in output results in
` 12.21 change in total cost. Thus is an estimate of marginal cost.

Activity 4

Suppose, for example, that the estimation process had given the following
figures for the coefficients:

log QD = log 200 – 1.5 log P + 2.4 log A

where QD is quantity demanded

P is own price and
A is advertising expenditure

What can we deduce from the estimated equation?

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60
 Basic Concepts &
3.10 DECISION UNDER RISK Techniques

The focus of this section is decision making under risk. The objective will be
to develop guidelines for making rational decisions given the decision makers
attitudes towards risk Attitudes towards risk may be of three types: (a) A risk-
seeker is one who prefers risk, given a choice between more or less risky
investments, with identical expected money returns; he will select the riskier
investment. (b) A risk averter is one who faced with the same situation will
select the less risky investment. (c) A risk-neutral person is one who faced
with the same situation will be indifferent to the choice. For him any
investment is equally preferable to the other. It is difficult to slot people in
one of these categories. You would perhaps have observed both risk averse
and risk seeking behaviour in the real world.

The analysis of risk is based largely on the concepts of probability and

probability distribution that are commonly encountered in elementary
statistics. First the terms strategy, states of nature and outcomes need to be
defined. A strategy is one of the many alternative plans or courses of action
that could be implemented in order to achieve managerial goal. A manager
might be considering three strategies to increase profits - build a more
modern plant which may produce at low cost, implement a new marketing
programme to increase sales or change the design of product to decrease cost
and increase sales.

A state of nature is a condition that may exist in the future and that will have
a significant effect on the success of a strategy. For example, the manager
may not be aware of the economic conditions in the future. The possible
states of nature may be normal, recession or boom.

The outcome results in either gain or loss based on a particular combination

of strategy and state of nature. The decision maker has no control over the
states of nature that will prevail in future but the future states of nature will
certainly affect the outcome of any strategy that he or she may adopt. The
particular decision made will depend, therefore, on the decision maker’s
knowledge or estimation of how a particular future state of nature will affect
the outcome of each particular strategy.

Given a set of outcomes, , and the probability of each occurring, , three

statistics relating to probability distributions can be used.

 The expected value of mean is a measure of expected return. This is

represented by

Where is the probability of is the outcome.

 The standard deviation is a measure of risk. This is represented by 61

Introduction to
Managerial Economics

 The coefficient of variation is a measure of risk per unit of money of

return.

These statistics have a direct application in measuring the expected return and
risk associated with any business decision for which a set of outcomes and
their probabilities have been determined. The expected value, standard
deviation, and the coefficient will be referred to as risk-return evaluation
statistics.

Having defined risk and reviewed some of the related terminology, the task
now is to develop quantitative measures of return and risk and to show how
they are applied in decision making. We know that individuals have different
preferences concerning risk taking. It is also important that such preferences
be identified and their effect on decisions evaluated. Rational decision
making requires that the expected return be determined and the risk be
measured, and that there be information about the manager’s preference for
risk. The expected value, the standard deviation, and the coefficient of
variation will be referred to as risk-return evaluation statistics.

Let us take an example where two investments, I and II, are being considered.
Both investments require an initial cash outlay of Rs.100 and have a life of
five years. The return on each depends on the rate of inflation over the five-
year period. Of course, the inflation rate is not known with certainty, but
suppose that the collective judgment of economists is that the probability of
no inflation is 0.20, the probability of moderate inflation is 0.50, and the
probability of rapid inflation is 0.30. The outcomes are defined as the present
value of net profits for the next five years. These outcomes for each state of
nature (i.e., rate of inflation) for each investment are shown in table 3.3.

Analysis of these investments can be made by calculating and comparing the

three evaluation statistics for each alternative. The expected value µ is an
estimate of the expected return for the investment. Because risk has been
defined in terms of the variability in outcomes, the standard deviation s is a
measure of risk associated with the investment. The larger the µ the greater is
the risk. Risk per rupee of expected return is measured by the coefficient of
variation (v).

The evaluation statistics for each investment alternative are computed as

follows:

0.2 100 0.5 200 0.3 400 240

62
 Basic Concepts &
Techniques
0.2 100 240 0.5 200 240 0.3 400 240

111.36
= 111.36/240 = 0.46

0.2 150 0.5 200 0.3 250 205

0.2 150 205 0.5 200 205 0.3 250 205 0.35
0.35
0.17
205

The expected return for investment I of ` 240 is higher than for II `.205, but
I is a riskier investment because = 111.36 is greater than = 0.35. Also,
risk per dollar of expected returns for I ( = 0.46) is higher than’ for ( =
0.17). Which is the better investment? The choice is not clear. It depends on
the investor’s attitude about taking risks. A young entrepreneur may well
prefer I, whereas an older worker investing in a retirement account where risk
ought to be minimized might prefer II. Generally higher returns are
associated with higher risk.

Table 3.3: Probability Distribution for Two Investment Alternatives

State of Nature Probability (Pi ) Outcome(Xi )
Investment I
No inflation 0.20 100
Moderate inflation 0.50 200
Rapid inflation 0.30 400
Investment II
No inflation 0.20 150
Moderate inflation 0.50 200
Rapid inflation 0.30 250

Decision Tree
Some strategic decisions are based on a sequence of decisions, states of
nature and possibly even strategic decisions. Alternative strategies can be
evaluated then, by using a decision tree, which traces sequences of strategies
and states of nature to arrive at a set of outcomes. The probability of each
outcome is found by multiplying the probabilities on each branch leading to
that outcome.
A decision tree shows two or more branches at each point where a decision or
event (state of nature) leads to the various outcomes. The decision tree
approach can be directly applied to managerial decision-making. A firm
entering a new market may decide to build a small or large plant (managerial
decisions). This has no probabilities. But there may be stochastic elements
(an outcome determined by chance) associated with each decision e.g.,
reaction of a major competitor and the economic condition. The competitor
may react by starting a national, regional, or a new advertising program. The
probability of each occurrence will depend on the size of the plant.
63
Introduction to The possible economic conditions and then probabilities may be recession,
Managerial Economics normal or boom. Here also the probability will depend on the size of the
plant. The probability of each combination is found by multiplying the
probability along each of the branches leading to the outcome. For example,
if the manager decides to build a large plant there is a 70 per cent chance that
the competitor will respond with a national advertisement. We are given that
there is a 30 per cent chance of a boom. The probability associated with the
outcome of 80 is therefore 0.21 (=0.7*0.3). Similar for other entries in the
decision tree.

Decision trees are particularly useful if sequential decision-making is

involved. In a game of chess, white has the first move. White has several
options at this stage. To keep the problem tractable, let us assume that there
are four possible moves for white : (i) move the king’s pawn two squares; (ii)
move the queen’s pawn two squares; (iii) move the king’s knight to king
bishop three; and (iv) move the queen’s knight to queen bishop three. In
chess notation, the four moves are - (i) e4; (ii) d4; (iii) Nf 3; and (iv) Nc 3.
Once white has made the first move, Black has several different moves at his
disposal. To keep the problem tractable, let us follow the decision tree only
when white has moved e4. Even then, Black has several moves at his
disposal. Let us assume that he has only four options - (i) move the king’s
pawn two squares (e5), (ii) move the queen’s pawn two squares (d5); (iii)
move the queen’s bishop’s pawn two squares (c5); and (iv) move the king’s
pawn one square (e6). Once white has moved e4 on the first move and Black
has moved e5 on the first move, white has several moves at his disposal. One
of them is, move the king’s knight to bishop three (Nf3). And so the game
goes on.

Figure 3.17 : Decision Tree

Each vertex or node indicates a decision to be taken by one of the players, the
number within the rectangle indicating whose turn it is to move. There need
not actually be two players, one of the players can be regarded as nature or
chance. The main advantage of using a decision tree is that it helps one to
64 isolate each chain and follow it through to the very end.
 Basic Concepts &
3.11 UNCERTAINTY ANALYSIS AND DECISION Techniques
MAKING
Certainty appears to be a theoretical and impractical state, as here the investor
has perfect knowledge of the investment environment such that he is definite
about the size, regularity and periodicity of flow of returns. Such situations
may exist in the short-run (e.g. fixed deposit in a nationalised bank).
However, long-run or long-range investments are not predictable as they are
influenced by many kinds of changes taking place with time: political,
economic, market and technology etc.

Risk is more common in the real world. A situation with more than one
possible outcome to a decision such that the probability of each of these
outcomes can be measured is a risk situation. For example, tossing of a coin
(i.e. 50-50) or investing in a stock. The greater the number and range of
outcomes, the greater is the risk associated with the decision or action.
Uncertainty is a situation where there is more than one possible outcome to a
decision but the probability of each specific outcome occurring is not known
or even meaningful. This may be due to insufficient information or instability
in the nature of variables. In extremes cases of uncertainty, the outcomes may
itself be not clear. Decision making under uncertainty is necessarily
subjective.

A Case Study of an American multinational chain of fast food

restaurants Burger’s which failed miserably.

This is a case study of a well-known American fast-food company which

offers affordable as well as high quality products. On an average 11 million
people visit the restaurants all over the world. Burger’s are one of the most
important products of fast food companies; The Fast food restaurant itself
gets one order of burger for every two orders.

When health trends set in, the fast food restaurant noticed that its burger
sales were dipping in USA. To attract health-conscious customers back it
decided to launch new type of healthier burgers which contained 40% less fat
and 30% less calories. They launched new type of burgers based on several
assumptions such as their customers wanted healthier options and were ready
to pay more for that. It was a very calculated risk taken by the company
based on the ongoing trend of health.

The product which was launched as a game changer in fast food market,
failed to attract the customers and it was discontinued within one year. It was
a major blow to the global fast food giant which was struggling to provide
fast food at its restaurants. There were several explanations given by experts
on why this product could not stabilize. But one thing is clear, what
customers say/want and do are completely different things altogether, so
there is always uncertainty in business environment which cannot be
eliminated.

This case clearly shows that even a well-conceived strategy is risky and can
lead to results estimated to have a small probability of occurrence. Indeed
the failure rate for new products in the United States is a stunning 80 percent.
65
Introduction to
Managerial Economics
3.12 ROLE OF MANAGERIAL ECONOMIST
In general, managerial economics can be used by the goal-oriented manager
in two ways. First, given an existing economic environment, the principles of
managerial economics provide a framework for evaluating whether resources
are being allocated efficiently within a firm. For example, economics can
help the manager if profit could be increased by reallocating labour from a
marketing activity to the production line. Second, these principles help the
manager to respond to various economic signals. For example, given an
increase in the price of output or the development of a new lower-cost
production technology, the appropriate managerial response would be to
increase output. Alternatively, an increase in the price of one input, say
labour, may be a signal to substitute other inputs, such as capital, for labour
in the production process.

Thus, the working knowledge of the principles of managerial economics can

increase the value of both the firm and the manager.

3.13 SUMMARY
Various quantitative tools are used by the manager to help him in making
decisions.
An opportunity set is a set of alternative actions which are feasible. Variables
are things which can change and can take a set of possible values within a
given problem. A function shows the relation between two variables. It can
take different forms-linear, quadratic, cubic. Partial derivatives are functions
of all variables entering into the original function f(x). Optimisation is the act
of choosing the best alternative out of all available ones. Regression analysis
helps to determine values of the parameters of a function - Economic analysis
of risk becomes crucial with reference to decisions.

3.14 SELF-ASSESSMENT QUESTIONS

1. Find the present value of Rs.10,000 due in one year if the discount rate is
5 per cent, 8 per cent, 10 per cent, 15 per cent, 20 per cent and 25 per
cent.

2. Apply the decision making model to your decision to attend college at

MBA level.

3. Discuss with examples how managerial economics is an integral part of

business activity.

4. Suppose a seller has two markets to serve. The demand schedules in them
are given in the table. Suppose that he has 1400 units to sell and
maximize profits thereby. What prices will he set in the two markets?
Apply equi-incrementalism principle to get your answer. Could you have
applied equi-marginalism.
66
 Basic Concepts &
Techniques
Market A Market B
Price ` Quantity Price ` Quantity
50 400 60 600
40 600 50 800
30 900 40 1100
20 1000 34 1400

[Hint: First get total revenue in each market by multiplying price with
quantity.]

5. A firm is producing two products x and y, and has the following profit
function 64 2 4 4 32 14 . Find the profit
Maximizing levels of output for each of the two products. (Ans.: x = 40, y
= 24, p = 1650).

6. Maximize 10 2
Subject to x + y = 12

7. What are central or basic problems of an economy?

8. Which problems of an economy constitute the subject matter of

microeconomics

3.15 FURTHER READINGS

Koutsoyiannis, A. (2018). Modern Microeconomics (2nd Ed.). Macmillian
Publishers India

Baumol, W.J.(1979). Economic Theory and Operations Analysis (4th Ed.)

Prentice Hall India, New Delhi.

Lewis, W.C., Jain, S.K., & Peterson, H.C. (2005). Managerial Economics (4th
Ed.). Pearson.

67
Introduction to The standard rules of differentiation in calculus are given below:
Managerial Economics
Appendix

A. Basic rule:

B. Additional rule:

C. Product rule: ∗

D. Quotient rule:

E. Chain rule:
∗

F. Logarithm rule: log

1

G. Exponential rule:

68