Managerial Economics

Module 1
 Topics
• Introduction : Basic Economic Problems
• Economic System – Micro and Macro Economics
• Nature and Scope of Managerial Economics
• Incremental, Discounting, Opportunity Cost, Time
and Equi Marginal Concept.
• Business Decision Making – Certainty, Risk and
Uncertainty.
• Applications of Economics in Managerial Decision
Making.
 Introduction
Economics:
• Economics is the study of how societies use
scarce resources to produce valuable
commodities and distribute them among
different people.
• The term economics is derived from two
Greek words “OIKOS”(a house) and
“NEMEIN”(to manage).
 Adam Smith - 1776
• “An enquiry into the nature and causes of the
wealth of nations.”
 Nearly 150 years later...
• “Economics is the study of mankind in the
ordinary business of life, it examines that part
of individual and social action which is closely
connected with the attainment and use of the
material requisites of well being.”
Alfred Marshall
 More Recently (1932)
• “Economics is the science which studies
human behaviour as a relationship between
ends and scarce means which have alternative
uses.”
Lionel Robbins
 Introduction

Points ….
• Efficient use of scarce resources…….
• Unlimited wants…
• Limited means….
• Having alternative uses…
 Why Study Economics?
• To understand the world better
– You’ll begin to understand the cause of many of the things
that affect your life.
• To gain self-confidence
– You’ll lose that feeling that mysterious, inexplicable forces
are shaping your life for you.
• To achieve social change
– understand origins of social problems and design more
effective solutions.
• To help prepare for other careers
– You’ll discover that a wide range of careers deal with
economic issues on many levels.
 Economics

Micro Macro
Economics Economics
 Microeconomics
• The branch of economics that analyzes the
market behavior of individual consumers and
firms in an attempt to understand the
decision-making process of firms and
households.
• It is concerned with the interaction between
individual buyers and sellers and the factors
that influence the choices made by buyers and
sellers.
 Macroeconomics
• The field of economics that studies the
behavior of the aggregate economy.
• Macroeconomics examines economy-wide
phenomena such as changes in
unemployment, national income, rate of
growth, gross domestic product, inflation and
price levels.
 Basic Economic Problems
• Microeconomic Problems
• Macroeconomic Problems
 Microeconomic Problems
• What to produce?
• How much to produce?
• How to produce?
• For whom to produce?
 Microeconomic Problems
• What to Produce?
– Scarcity of resources.
– All goods and services are not equally valued in
terms of their utility by consumers.
• Since all goods and services cannot be produced
and,
• All that is produced may not bought, the problem
of choice between the commodities arises (i.e.
problem of “what to produce?”)
 Microeconomic Problems
• How Much to Produce?
– Problem of determining the quantity of each
commodity and service to be produced.
– Arises due to scarcity of resources.
• Surplus production would mean wastage of
scarce resources.
 Microeconomic Problems
• How to Produce?
– It is the problem of the choice of technique.
– Here the problem is to determine the optimum
combination of inputs – labour and capital.
– Also another factor is that a given quantity of a
commodity can be produced with a number of
alternative techniques.
 Microeconomic Problems
• For Whom to Produce?
– All goods and services are produced by business
firms.
– The total output generated is called the ‘society’s
total output’ or ‘national output’.
– The problem is how is this output shared among
households or what determines the share of each
household?
 Macroeconomic Problems
• How to increase production capacity?
• How to stabilize the economy?
• Unemployment.
• Inflation.
• Balance of Payments.
 Economic System
• An economic system describes how a
country’s economy is organized
• Because of the problem of scarcity, every
country needs a system to determine how to
use its productive resources
• Scarcity = not having enough of something
 Economic System - Types
• Free Enterprise Economies.
• Government Controlled or Command
Economies.
• Mixed Economies.
 Free Enterprise Economies
• An economic system in which production and
distribution questions are answered by prices and
profits (supply and demand)
• Most of the resources are owned by private
citizens.
• Economic decisions are based on Free Enterprise.
(competition between companies)
• Important economic questions are not answered
by govt. but by individuals
• Govt. does not tell a business what goods to
produce or what price to charge.
 Free Enterprise Economies
• Who decides what to produce?
– Businesses base decisions on supply and demand
and free enterprise (PRICE)
• Who decides how to produce goods and
services?
– Businesses decide how to produce goods
• Who are the goods and services produced for?
– consumers
 Free Enterprise Economies
• Private Ownership of means of production.
• Private Gains as motivating force.
• Freedom of Choice. (produce and consume)
• Freedom of occupational choice. (to employ
resources)
• Free competition.
• The USA is a close resemblance of a free
enterprise economy.
 Government Controlled or Command
Economies
• Government makes all economic decisions &
owns most of the property.
• Governmental planning groups determine
such things as the prices of goods/services &
the wages of workers.
• This system has not been very successful &
more and more countries are abandoning it.
 Government Controlled or Command
Economies
• Who decides what to produce?
– Government makes all economic decisions.
• Who decides how to produce goods and
services?
– Government decides how to make goods/services.
• Who are the goods and services produced for?
– Whoever the government decides to give them to.
 Government Controlled or Command
Economies
• Countries with communist governments have
Command economies
• Examples: There are no truly pure command
economic systems, but close countries are:
North Korea, former Soviet Union, Cuba
• Germany and Russia have moved away from
having a Command economy since 1991. Now
they have a Mixed economy.
 Mixed Economies
• Free + Command = Mixed
• There are no pure command or market
economies.
– To some degree, all modern economies exhibit
characteristics of both systems and are often referred
to as mixed economies.
– Most economies are closer to one type of economic
system than another.
• Businesses own most resources and determine
what and how to produce, but the government
regulates certain industries.
 Mixed Economies
• Who decides what to produce?
– businesses
• Who decides how to produce goods and
services?
– Businesses, but the government regulates certain
industries
• Who are the goods and services produced for?
– consumers
 Mixed Economies
• Mixed Capitalist Economies. (US, UK,
Germany, France, Japan)
• Mixed Socialist Economies. (India, Russia,
China)
 Managerial Economics
• Managerial Economics is "concerned with
application of economic concepts and
economic analysis to the problems of
formulating rational managerial decision”.
Edwin Mansfield
 Managerial Economics
• Managerial Economics “is the integration of
economic theory with business practice for
the purpose of facilitating decision making
and forward planning by the management.”
Spencer and Seigelman
 Managerial Economics
• “Managerial Economics applies the principles
and methods of economics to analyze
problems faced by management of a business
or other types of organisations and help to
find solutions that advance the best interest of
the organisation.”
Davis and Chang
 Nature of Managerial Economics
• Microeconomics.
• Normative Economics. (What management should do
under particular circumstances)
• Pragmatic.
• Uses Theory of the Firm.
• Takes the help of Macroeconomics.
• Aims at helping the management.
 Scope of Managerial Economics
• Demand Analysis and Forecasting
• Cost and Production Analysis
• Pricing Decisions, Policies and Practices
• Profit Management
• Capital Management
• Environmental Issues
 Scope of Managerial Economics
• Demand Analysis and Forecasting:
– A business firm is an economic organisation that
transforms productive resources into goods that are
to be sold in a market.
– Demand forecasting for making an estimate of future
sales.
– Essential for preparing production schedule and
employing productive resources.
– Helps to identify factors that influence demand for a
product.
 Scope of Managerial Economics
• Cost and Production Analysis:
– Profitability depends on costs of production.
– Involves:
• Preparing cost estimates of a range of output.
• Identifying factors causing variations in costs and,
• Choosing the cost minimising output level.
 Scope of Managerial Economics
• Pricing Decisions, Policies and Practices:
– Pricing decisions are to be taken after careful
analysis of the market in which the firm operates.
– Affects demand for a particular product.
 Scope of Managerial Economics
• Profit Management:
– Profits are the reward for uncertainty and risk
bearing.
– It is the difference between Total Revenue and
Total Cost.
– The more successful a firm is in reducing
uncertainty, the higher will be the profits earned.
 Scope of Managerial Economics
• Capital Management:
– Means the planning and control of capital
expenditure.
– Involves:
• Selection of most suitable investment project.
• Most efficient allocation of capital.
• Assessing the efficiency of capital
• Minimising the possibility of under capitalisation or
over capitalisation.
 Scope of Managerial Economics
• Environmental Issues:
– Type of Economic System
– Business Cycles
– Industrial Policy
– Trade and Fiscal Policy
– Taxation Policy
– Price and Labour Policy
 Fundamental Concepts of Managerial
Economics
• Principle of Opportunity cost
• Principle of Incremental cost
• Principle of Time perspective
• Principle of Discounting
• Equimarginal Principle
 Fundamental Concepts of Managerial
Economics
Opportunity Cost Concept:
• By the opportunity cost of a decision we mean the sacrifice of alternatives
required by that decision.
• For e.g.:
a) The opportunity cost of using a machine to produce one product is the
earnings forgone which would have been possible from other products.
b) The opportunity cost of holding Rs. 1000as cash in hand for one year is the
10% rate of interest, which would have been earned had the money been kept as
fixed deposit in bank.

• Its clear now that opportunity cost requires ascertainment of sacrifices. If a

decision involves no sacrifices, its opportunity cost is nil. For decision making
opportunity costs are the only relevant costs.
 Fundamental Concepts of Managerial
Economics
Incremental Cost Concept:
• It is related to the marginal cost and marginal revenues, for economic
theory.
• Incremental concept involves estimating the impact of decision alternatives
on costs and revenue, emphasizing the changes in total cost and total
revenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decisions.
• The two basic components of incremental reasoning are
– Incremental cost
– Incremental Revenue
• The incremental principle may be stated as under:
– “A decision is obviously a profitable one if –
– it increases revenue more than costs
– it decreases some costs to a greater extent than it increases others
– it increases some revenues more than it decreases others and
– it reduces cost more than revenues”
 Fundamental Concepts of Managerial
Economics
Time Concept:
• Managerial economists are also concerned with the
short run and the long run effects of decisions on
revenues as well as costs.
• The very important problem in decision making is to
maintain the right balance between the long run and
short run considerations.
 Fundamental Concepts of Managerial
Economics
Discounting Concept:
• One of the fundamental ideas in Economics is that a
rupee tomorrow is worth less than a rupee today.
• Suppose a person is offered a choice to make between
a gift of Rs.100/- today or Rs.100/- next year. Naturally
he will chose Rs.100/- today. This is true for two
reasons-
• The future is uncertain and there may be uncertainty in getting Rs.
100/- if the present opportunity is not availed of.

• Even if he is sure to receive the gift in future, today’s Rs.100/- can

be invested so as to earn interest say as 8% so that one year after
Rs.100/- will become 108.
 Fundamental Concepts of Managerial
Economics
Equimarginal Concept:
• This principle deals with the allocation of an available
resource among the alternative activities.
• According to this principle, an input should be so
allocated that the value added by the last unit is the
same in all cases. This generalization is called the equi-
marginal principle.
• This states that the available resources (inputs) should
be so allocated between the alternatives that the MP
(marginal productivity) gains from the various activities
are equalized.
 Decision Making
• Act of choosing; process of converting
information into action.
• May or may not be result from an immediate
problem.
• Purpose of decision making is to identify a
course of action.
 Core Elements of Decision Making

• Identification of problem, issue or situation

• Establishment of criteria
• Search for alternative solutions or actions
• Evaluation of alternatives
• Selection of a particular alternative
 Phases of Decision Making
• Deliberation
• Judgment
• Choice
 Steps in Decision Making
1. Become aware of the situation .
2. Investigate the nature of the situation.
3. Determine the objective of the solution.
4. Determine the alternatives.
5. Weigh the consequences of alternatives.
6. Evaluate or pilot test alternatives.
7. Select the best alternative.
8. Implement the decision- communicate, train.
9. Evaluate the solution at intervals.
10. Correct, change or withdraw the solution.
 1. Defining a decision
• Recognition of a problem arises
• Diagnosis is made.
• The manager should first determine or
specify his task,
• ie The aim or purpose to be achieved.
 2. Analysing a decision
• What is the decision for?
• What will it change?
• What will it achieve?
• And whom will it affect?
 3. Reviewing factors
• Review the different factors which
affect a situation.
 4. Analysing possible course of action
• Analyze all the possible alternatives.
• Having examined all the relevant factors,
• It should become clear that there are a
number of courses of action open to us.
 5. Choosing the best alternative
• A particular course of action is selected from
among those which are available.
 6. Implementing decision
• The process of decision is not complete until it
is implemented and
• we have learnt to live with the consequences.
 7. Evaluating decision
• The last step is decision making is
the evaluation of the decision.
• Sometimes, there is vigorous
criticism of the decision that has
been made.
 Management Decision Problems

 Product Price and Output

 Make or Buy
 Production Technique
 Stock Levels
 Advertising Media and Intensity
 Labor Hiring and Training
 Investment and Financing