Basic Tools In Managerial

Economics

Opportunity Cost
Discounting Principle
Marginalism and Incremental Principle
Time Perspective
Demand Analysis
 Opportunity Cost

In Words of Ferguson “the alternative or

opportunity cost of producing one unit of
commodity ‘X’ is the amount of commodity
‘Y’, that must be sacrificed in order to use
resources to produce , ‘X’ rather than ‘Y’.’’
Example:
 The opportunity cost of the funds employed
in one’s own business is the interest that
could be earned on those funds had they
been employed in other venture.

The opportunity cost of the time of

entrepreneur devotes to his own business
is the salary he could earn by working
somewhere else.
Important Features
Opportunity costs require ascertainment of
sacrifice . If a decision involves no sacrifice,
its opportunity cost is Zero

If there is unutilized plant capacity, or if workers

do not have sufficient work to engage it for
requisite number of hours, the opportunity
cost of plant capacity is zero

Opportunity cost involve measurement of the

sacrifice which can be monetary or real.
Monetary sacrifice can be expressed as
explicit cost, recognized in the book of accounts.
Real sacrifice may be expressed only as implicit
cost, not recognized in the book accounts.
Explicit Cost :

The out-of-pocket monetary payments made

for market supplied inputs (labour services,
raw material and capital equipment).

Example:

If Dell Computer Company require micropr-

ocessor chip to manufacture its ‘8300 model
personal computer’. This chip costed $300.
Thus it is explicit cost because it has to be
paid to owner of input.
The opportunity cost to obtain Chip is $300/
–
Implicit cost:

The non-monetary out-of-pocket payments

made for using owner-supplied resources
(time and labour services provided by firm's
owner and any land, buildings or capital
equipment owned and used by the firm).

Example
If firm owners are not managing their own business,
They could obtain jobs with some other firms. The
salary that could be earned in an alternative
occupation is an implicit cost which is part of
the total cost of production because it is an oppor-
tunity cost to these owners.
 Measurement of Opportunity
cost
For example, in this
diagram, the decision
to increase the
production of
computers from 5 to
6 (from point Q to
point R) requires a
minimum loss of food
output. However, the
decision to add a
tenth computer (from
point T to point V)
has a much more
substantial
opportunity cost.
 The Law of Increasing
Opportunity Cost
•The slope of the PPF
curve is also called the
marginal rate of
transformation (MRT).

•The negative slope of

the PPF curve reflects the
law of increasing
opportunity cost. As we
increase the production
of one good, we sacrifice
progressively more of the
other.
 Problem
A engineer turns down a job offer at Rs. 30,000/- to
start his own business.
He has invested Rs.50,000 of his own money which has
been in a bank account earning 7%
rate of interest per year.
Revenue from the new business during the first year
was of Rs.107,000/-
Other expenses were-
Advertising – Rs. 5000/
Rent Rs/ 10000/-
Taxes 5,000/-
Employee salaries - Rs.40,000
Suppler Rs. 5000/-
Prepare tow income statement using the traditional
accounting approach and one using opportunity cost
approach to determine profit.
Marginalism & Incrementalism
In economic theory any firm makes a decision
to produce by equating marginal revenues
with marginal costs. (MR=MC).
Marginal Revenue – is the change in Total
revenue resulting from an one–unit change
in the volume of output produce (firm decides
to produce n+1).
Marginal Cost-It refers to the cost of produ-
cing additional unit of output.
Marginal Product – it is the addition made to
total produce as a result of employing an
additional factor of production. (Labour)
Marginalism & Incrementalism

In making economic decision, management

is interested in knowing the impact of a
chunk-change rather than a unit change .

Marginal concepts are always defined in

terms of unit changes, but incremental
concepts are defined in terms of chunk
changes .
Incremental principle concept refers to :

Incremental Revenue - Change in total

revenue caused by a decision.

IR = TR (IR = Incremental Revenue)

Q (TR = Total Revenue)
(Q= Total Output)
IR = TR
I (I = Total Investment)
Incremental Cost - Change in total cost.

IC = TC (IC = Incremental Cost)

Q (TC = Total Cost)
(Q = Total Output)

Managerial Rule of Thumb-

 IR >IC
 Example
An automobile firm adopts a new factory plant to
increase its output. This may involve a rise in its
total cost by 20% against increase in output by
10%.
IC = 20% = 2%
10%
 On other hand, firm expects rise in total sale
revenue by 30% because of increase in 10%
output.
 IR = 30% = 3% ( IR= 3% > IC = 2%)
10%
 The incremental principle may be stated as
under :

A decision is obviously a profitable one if

(i) It increases revenue more than costs.
(ii) Reduces costs more than revenue

Incremental revenue and incremental cost are

two basic concepts for making optimum
economic decisions. A decision is optimum if it
reduces cost more than revenue i.e. if the net
incremental revenue is positive.
 Equi-Marginalism
Since resources are limited a very fundamental
questions arises : How to decide on an optim-
um allocation of resources. When we use
resources, we get returns in either physical
volume or its money value.

If there is only one resource, then we may go

on utilizing it till its Marginal return is zero i.e.
Do not go beyond zero marginal return , if a
resource has only one use. This is known as ”
absolute activity level principle”. (Consider
given example)
.
 Illustration
No. of Total Average Marginal
Labourers Output Output Output
1 12 12.0 -
2 22 11.0 10
3 33 11.0 11
4 47 11.8 14
5 59 11.8 12
6 68 11.3 9
7 72 10.3 4
8 72 9.0 0
9 70 7.7 -2
 Illustration
No. of Marginal output From
Labourers Project A Project B Project C

1st 10 9 8
2nd 9 8 7
3rd 8 7 6
4th 7 6 5
5th 6 5 4
6th 5 4 3
The equi-marginal principle deals with the
allocation of the available resources among the
alternative activities.

The Principle of equi-marginal return or

“Relative Activity Level Principle” states that a
resource should be allocated in such a way so
that the value added by the last unit is the
same in all uses.
 But a resource may have various uses. The
question arises that how a resource should be
used in alternative activities?
When six labourers are at disposal, the
optimum allocation of labour resources –
3 labors – A Project (Yield a total output of
27)
2 Labors –B Project (Yield a total output of
17)
1 Labors – C Project (Yield a total output of
8)
Total returns are maximum at 52, when
marginal return from each project is 8.
Discounting Principle/Present
Value Analysis
Many transaction involve making or
receiving cash payments at various
future dates.
– A person who takes out a mortgage loan
trades a promise to make monthly
payment for thirty years for a large
amount of cash now to pay for a home.
– A person injured in an automobile
accident accepts an insurance company’s
settlement of $1,000 per month for life
as compensation for the damage
associated with the injury.
Time value of money make sound
decisions making or receiving cash
payment at future date.

Time value of Money : refers to the fact

that a Dollar/Rupee to be received in the
future is not worth a $/Rs. Today.

It is important to know a technique to

measure present value of dollar to be
received or paid at different points in the
future.
 Present Value of Rs.100 @ 15%
received in different years
Rs100 received Present value Working
in
Y-1 86.96 100/ (1.15)1
Y-2 75.61 100/(1.15)2
Y-3 65.75 100/(1.15)3
Y-4 57.18 100/(1.15)4
Y-5 49.72 100/(1.15)5
Y-10 24.72 100/(1.15)10
Y-25 3.04 100/(1.15)25
Y-50 .09 100/(1.15)50
 Annuity :A series of equal payments per
period for a specified length of time. Specific
installments for loan payment.

Amount :A specific number of dollars

to be paid or received on specific date.

Present Value : The value today of an

amount or an annuity taking into
consideration that interest can be earned.
 Present Value of an Amount
PV = $ /(1+i)n

The bracketed term is present value of

$ 1 in n period if the interest rate is i%.

It is called present –value-interest-

factor.
 Example
What is the present value of $1,080 in 1
year if the interest rate is 8% per year?

PV = $1080 /(1.08)1
= $1,000
In one year $1,000 would increase to
$1,080 at 8% interest. Present value
takes account the potential interest,
 Time Perspective
Economics normally make a distinction
between “Short- Run” and “ Long-Run”.

By Short -Run , the reference is to the time

period when the structure of industry , the size
of firm and the scale of plant are not alterable;
the time is so short that any change in the
scale of output has to be brought about by
changing the intensity of exploiting the fixed
factors like land and machineries.

In ”long- Run” all factors become variable ;

then enough time is available to adjust the
scale of plant, size of firm and the structure
of industry so as to change the volume of
output.