Examine the fundamental concepts of applied in managerial decision making?

Managerial Economics is both conceptual and metrical. Before the substantive decision problems
which fall within the purview of managerial economics are discussed, it is useful to identify and
understand some of the basic concepts underlying the subject. Economic theory provides a number of
concepts and analytical tools which can be of considerable and immense help to a manager in taking
many decisions and business planning. This is not to say that economics has all the solutions. In fact,
actual problem solving in business has found that there exists a wide disparity between economic
theory of the firm and actual observed practice.

There are six basic principles of managerial economics. They are:

1. The Incremental Concept

The Concept of Time Perspective

3. The Opportunity Cost Concept

4. The Discounting Concept

5. The Equi-marginal Concept

6. Risk and Uncertainty

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.

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.

The time perspective concept states that the decision maker must give due consideration both to the
short run and long run effects of his decisions. He must give due emphasis to the various time
periods. It was Marshall who introduced time element in economic theory.

The economic concepts of the long run and the short run have become part of everyday language.
Managerial economists are also concerned with the short run and long run effects of decisions on
revenues as well as costs. The main problem in decision making is to establish the right balance
between long run and short run.

In the short period, the firm can change its output without changing its size. In the long period, the
firm can change its output by changing its size. In the short period, the output of the industry is fixed
because the firms cannot change their size of operation and they can vary only variable factors. In the
long period, the output of the industry is likely to be more because the firms have enough time to
increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average revenue. In
the long period, the average cost of the firm will be equal to its average revenue. A decision may be
made on the basis of short run considerations, but may as time elapses have long run repercussions
which make it more or less profitable than it at first appeared.

3. The Opportunity Cost Concept:

Both micro and macro economics make abundant use of the fundamental concept of opportunity cost.
In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its
significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a
choice between different alternative courses of action.

Resources are scarce, we cannot produce all the commodities. For the production of one commodity,
we have to forego the production of another commodity. We cannot have everything we want. We
are, therefore, forced to make a choice.
Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of
alternatives is involved when carrying out a decision requires using a resource that is limited in
supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by
pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

1. The calculation of opportunity cost involves the measurement of sacrifices.

2. Sacrifices may be monetary or real.

3. The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the
company. If resource has no alternative use, then its opportunity cost is nil.

In managerial decision making, the concept of opportunity cost occupies an important place. The
economic significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods.

2. It helps in determining normal remuneration to a factor of production.

3. It helps in proper allocation of factor resources.

Equi-Marginal Concept:

One of the widest known principles of economics is the equi-marginal principle. The principle states
that an input should be allocated so that value added by the last unit is the same in all cases. This
generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved
in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by
employing more labour but only at the cost i.e., sacrifice of other activities.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one
activity than in another. It would be, therefore, profitable to shift labour from low marginal value
activity to high marginal value activity, thus increasing the total value of all products taken together.

Discounting Concept:

This concept is an extension of the concept of time perspective. Since future is unknown and
incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth
more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand
is more worth than two in the bush.” This judgment is made not on account of the uncertainty
surrounding the future or the risk of inflation.

It is simply that in the intervening period a sum of money can earn a return which is ruled out if the
same sum is available only at the end of the period. In technical parlance, it is said that the present
value of one rupee available at the end of two years is the present value of one rupee available today.
The mathematical technique for adjusting for the time value of money and computing present value is
called ‘discounting’.

Risk and Uncertainty:

Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is
uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle,
structure of the economy and government policies.

This means that the management must assume the risk of making decisions for their institution in
uncertain and unknown economic conditions in the future. Firms may be uncertain about production,
market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not
known immediately for certain.

Economic theory generally assumes that the firm has perfect knowledge of its costs and demand
relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty
arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost
and revenue data of their firms with reasonable accuracy.
What is price elasticity of demand? What are its types ? Explain with suitable examples

Elasticity is a concept in economics that talks about the effect of change in one economic variable on
the other.

Elasticity of Demand, on the other hand, specifically measures the effect of change in an economic
variable on the quantity demanded of a product. There are several factors that affect the quantity
demanded for a product such as the income levels of people, price of the product, price of other
products in the segment, and various others.
Price elasticity of demand (PED) is a key concept related to the law of demand. It is an economic
measurement of how quantity demanded of a good will be affected by changes in its price. In other
words, it’s a way to figure out the responsiveness of consumers to fluctuations in price (as opposed to
price elasticity of supply, which determines the responsiveness of supply to price).

1. Price Elasticity of Demand (PED)

Any change in the price of a commodity, whether it’s a decrease or increase, affects the quantity
demanded for a product. For example, when there is a rise in the prices of ceiling fans, the quantity
demanded goes down.

This measure of responsiveness of quantity demanded when there is a change in price is termed as the
Price Elasticity of Demand (PED).

The mathematical formula given to calculate the Price Elasticity of Demand is:

PED = % Change in Quantity Demanded % / Change in Price

The result obtained from this formula determines the intensity of the effect of price change on the
quantity demanded for a commodity.

There are five types of price elasticity of demand. They are:

 Perfectly Elastic Demand

  Elastic Demand

 Perfectly Inelastic Demand

 Inelastic Demand

 Unitary Demand

Price Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Price)

Since quantity demanded usually decreases with price, the price elasticity coefficient is almost always
negative

Example: If a slice of pizza you purchased every day for lunch went up $0.50 would it affect your
purchase? As long as you weren't super attached to the pizza and had other options (more on this
below), you probably would move to another lunch establishment. The pizza, and food in general,
tends to be elastic, where even slightly higher prices may cause a change in demand.
1. Perfectly Elastic Demand:
When a small change in price of a product causes a major change in its demand, it is said to be
perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to
zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is
perfectly elastic or ep = 00.
The degree of elasticity of demand helps in defining the shape and slope of a demand curve.
Therefore, the elasticity of demand can be determined by the slope of the demand curve. Flatter the
slope of the demand curve, higher the elasticity of demand.

In perfectly elastic demand, the demand curve is represented as a horizontal straight line,
which is shown in Figure-2:
From Figure-2 it can be interpreted that at price OP, demand is infinite; however, a slight rise in price
would result in fall in demand to zero. It can also be interpreted from Figure-2 that at price P
consumers are ready to buy as much quantity of the product as they want. However, a small rise in
price would resist consumers to buy the product.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of a product
with change in its price. The numerical value for perfectly inelastic demand is zero (e p=0).
In case of perfectly inelastic demand, demand curve is represented as a straight vertical line,
which is shown in Figure-3:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to OP3
does not show any change in the demand of a product (OQ). The demand remains constant for any
value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical
situation. However, in case of essential goods, such as salt, the demand does not change with change
in price. Therefore, the demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change produced in demand is
greater than the proportionate change in price of a product. The numerical value of relatively elastic
demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic demand (e p>1). For
example, if the price of a product increases by 20% and the demand of the product decreases by 25%,
then the demand would be relatively elastic.
The demand curve of relatively elastic demand is gradually sloping, as shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to OQ2 is
relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic demand
has a practical application as demand for many of products respond in the same manner with respect
to change in their prices.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change produced in demand is less than the
percentage change in the price of a product. For example, if the price of a product increases by 30%
and the demand for the product decreases only by 10%, then the demand would be called relatively
inelastic. The numerical value of relatively elastic demand ranges between zero to one (e p<1).
Marshall has termed relatively inelastic demand as elasticity being less than unity.
The demand curve of relatively inelastic demand is rapidly sloping, as shown in Figure-5:

It can be interpreted from Figure-5 that the proportionate

change in demand from OQ1 to OQ2 is relatively smaller than the proportionate change in price from
OP1 to OP2. Relatively inelastic demand has a practical application as demand for many of products
respond in the same manner with respect to change in their prices.

Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the price of the product, the
demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal
to one (ep=1).
The demand curve for unitary elastic demand is represented as a rectangular hyperbola, as
shown in Figure-6:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces the same change in
demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

Explain the internal and external economies of scale?

An economy of scale is a microeconomic term that refers to factors driving production costs down
while increasing the volume of output. There are two types of economies of scale: internal
and external economies of scale. Internal economies of scale are firm-specific—or caused internally
—while external economies of scale occur based on larger changes outside the firm. Both result in
declining marginal costs of production, yet the net effect is the same.

Internal Economies of Scale

An internal economy of scale measures a company's efficiency of production. That efficiency is
attained as the company improves output when the average cost per product drops. This type of
economy of scale is a consequence of a company's size and is controlled by its management teams
such as workforce, production measures, and machinery. The factors, therefore, are independent of
the entire industry.
External Economies of Scale
External economies of scale are generally described as having an effect on the whole industry. So
when the industry grows, the average costs of business drop. External economies of scale can happen
because of positive and negative externalities. Positive externalities include a trained or specialized
workforce, relationships between suppliers, and/or more innovation. Negative ones happen at the
industry levels and are often called external diseconomies.

Internal economies of scale offer greater competitive advantages than external economies of scale.
This is because an external economy of scale tends to be shared among competitor firms. The
invention of the automobile or the internet helped producers of all kinds. If borrowing costs decline
across the entire economy because the government is engaged in expansionary monetary policy, the
lower rates can be captured by multiple firms. This does not mean any external economy of scale is a
wash. Companies can still take relatively greater or lesser advantage of external economies of scale.
Nevertheless, internal economies of scale embody a greater degree of exclusivity.

Construct imaginary schedules and show digarmatically with suitable explanation of

behaviours of average revenue and marginal revenue curves under perfect and imperfect
markets

Revenue is the income earned by a firm by the sale of goods and services. We may also say that the sale
value of the goods. Revenue is different from profit. Profit is equal to revenue less cost.

Average revenue

Average revenue is the revenue per unit of output sold in the market. In simple words, it is the price per
unit of the commodity. We calculate the Average revenue by dividing the Total revenue with the number
of units of output to be sold in the market. Thus,

AR=TR/Q

Marginal revenue

Marginal revenue refers to the additional revenue that a firm or producer obtains by selling every
additional unit of the commodity in the market. In other words, the change in total revenue is marginal
revenue. Thus,
MR=ΔTR/ΔQ

Or MR = TRn – TRn-1

Revenue curve under Perfect competition market

In the perfect market competition, there are a large number of small buyers and sellers. Thus, the firm is
the price taker. Also, in this situation, all the firms sell homogeneous goods.

Thus, the price remains constant but the revenue changes. Here, Average revenue curve is a straight line
parallel to X-axis. Also, in this situation AR = MR.

Revenue curve under Imperfect competition market

In the imperfect competition market, the price is not constant. It may increase or decrease due to
market forces.

In order to increase sales, the seller will have to reduce the price of the commodity. But, when the price
decreases, Average Revenue and Marginal Revenue also decrease.

In the imperfect competition market, both Average revenue curve and Marginal revenue curve slope
downwards from left to right.
Discuss the characteristics of monopolistic competitions and how price and output are
determined under it

In monopolistic competition, the market has features of both perfect competition and monopoly. A
monopolistic competition is more common than pure competition or pure monopoly. In this article, we
will understand monopolistic competition and look at the features, price-output determination, and
conditions for equilibrium.

1. Large number of sellers: In a market with monopolistic competition, there are a large number of
sellers who have a small share of the market.

2. Product differentiation: In monopolistic competition, all brands try to

create product differentiation to add an element of monopoly over the competing products. This
ensures that the product offered by the brand does not have a perfect substitute. Therefore, the
manufacturer can raise the price of the product without having to worry about losing all its
customers to other brands. However, in such a market, while all brands are not perfect substitutes,
they are close substitutes for each other. Hence, the seller might lose at least some customers to
his competitors.
3. Freedom of entry or exit: Like in perfect competition, firms can enter and exit the market freely.

4. Non-price competition: In monopolistic competition, sellers compete on factors other than price.
These factors include aggressive advertising, product development, better distribution, after sale
services, etc. Sellers don’t cut the price of their products but incur high costs for the promotion of
their goods. If the firms indulge in price-wars, which is the possibility under perfect competition,
some firms might get thrown out of the market.

Price-output determination under Monopolistic Competition: Equilibrium of a firm

In monopolistic competition, since the product is differentiated between firms, each firm does not have a
perfectly elastic demand for its products. In such a market, all firms determine the price of their own
products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity of
demand increases as the differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped
short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual firm are as follows:
 1. MC = MR

2. The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

 Equilibrium price = OP and

 Equilibrium output = OQ

Now, since the per unit cost is BQ, we have

 Per unit super-normal profit (price-cost) = AB or PC.

 Total super-normal profit = APCB

Examine break even analysis in the light of its assumptions and limitations

Break-even analysis is of vital importance in determining the practical application of cost functions. It
is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying the dynamic
relationship existing between total cost and sale volume of a company.

Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating condition that
exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred
in attaining that level of sales.

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Limitations of Break-Even Analysis:

We may now mention some important limitations which ought to be kept in mind while using
break-even analysis:
1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the help
of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small range of
output. It is not an effective tool for long-range use.

4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer from
various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and
inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.

6. Selling costs are specially difficult to handle break-even analysis. This is because changes in
selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate
income tax.

8. It usually assumes that the price of the output is given . In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a particular
period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a breakeven
point is considered an approximation rather than a reality.