Managerial

Economics
Unit 1

By Dr. Nandita Sharma

Topics to be covered
• Nature and scope of managerial economics
• Its relationship with subjects
• Objective of Firm
• Fundamental Economics Concepts
Opportunity cost concept
Incremental concept
Principle of perspective
Discounting principle
Equimarginal principle
Father of Economics
Adam Smith
What is Economics?
According to Adam Smith, “ Economics is an inquiry into the nature
and causes of the wealth of nations.”

According to Robbins, “Economics is the science which studies human

behaviour as relationship between ends and scarce means, which have
alternative uses.”
(Economic behaviour is making choice between the endless wants and
between the alternative uses of their limited resources for meeting
maximum number of their needs).
Thus, Economics can be defined as a social science that studies economic
behaviour of the people, the individuals, households, firms and the government.

Economics is trying to balance the unlimited requirements with limited resources.

Economics is defined as a technique or a tool of balancing most of the needs

which can be termed as a credit and the limited resources, which can be termed
as a debit. Keeping a proper and healthy balance between these two terms is
nothing but economics.

Economics as a social science studies how people allocate their limited resources
to their alternative uses with the objective of deriving maximum possible gains
from the use of their resources.
 Difference between
microeconomics and
macroeconomics
• Microeconomics is the study of the economizing behaviour of the
individual economic entities- individual, households, firms, industries
etc.
For ex, How individuals and households with limited income decide
‘what to consume’ and ‘how to consume’ so that the total utility is
maximized.
Similarly, business firm decide what to produce, for whom to produce,
how to produce, how much to produce, what price to charge, how to
promote sales to maximize profit.
• Macroeconomics studies the economic phenomena at the national
aggregate level.

Macroeconomics is the study of working and performance of the

economy as a whole.

Macroeconomics deals with large economic-related issues like entire

nation. Inflation, annual budgets, scarcity, poverty, etc. can come under
macroeconomics.
 Managerial Economics
According to McNair and Meriam, “Managerial Economics consists of
the use of economic modes of thought to analyse business situations.”
According to Spencer and Siegelman, “ Managerial Economics as the
integration of economic theory with business practice for the purpose
of facilitating decision making and forward planning by management.”
 Application of economics to
business management
• Reconciling traditional theoretical concepts of economics in relation
to the actual business behavior and conditions.
• Estimating economic relationships
• Predicting relevant economic quantities
• Using economic quantities
• Understanding significant external forces
 Micro
Economic in
Character

Aims at
Uses theory of
helping the
firm
management

Characteristics
of Managerial
Economics
Macro
economics is Pragmatic
also useful to (Application
managerial oriented)
economics Belong to
Normative
Economics
rather than
Positive
Economics
 Scope of Managerial
1.
Economics
Demand analysis and forecasting
2. Cost analysis (Analyse Cost concept and classification, cost output
relationships, Economies of scale and cost control)
3. Production and supply analysis (Analyse law of supply and factors
influencing supply)
4. Pricing decisions, policies and practices (Analyse price determination in
various market forms)
5. Profit management (Analyse nature and measurement of profit, profit
planning like Break-Even Analysis)
6. Capital management (Analyse cost of capital, rate of return and
selection of projects)
 Managerial and other subjects
1). Managerial Economics and Economics:
Business economists have found the following main areas of economics as useful
in their work:
• Demand theory
• Theory of the firm- price, output and investment decisions
• Business financing
• Public finance and fiscal policy
• National income
• International trade
• Economics in developing countries
2). Managerial Economics and Statistics:
• Quantitative data is helpful to take various decisions in business
• Theory of probability is based on statistics provides the logic for dealing
with uncertainty.

3). Managerial Economics and Mathematics:

• Managerial economics is metrical in character estimating various
economic relationships, predicting relevant economic quantities and
using them in decision making.
• Operation research which is purely related to Managerial Economics is
mathematical in character.
4) Managerial Economics and Accounting
• Accounting information is one of the principal sources of data required by
the managerial economist for decision making purpose.
• Management accounting is useful to solve managerial problems and helpful
for decision making.
Uses of Managerial Economics
• It presents those aspects of traditional economics which are relevant
for business decision-making in real life.
• It also incorporates useful ideas form other disciplines such as
psychology, sociology etc.
• Managerial economics helps in reaching a variety of business
decisions in a complicated environment.
• Managerial economics serves as an integrating agents by coordinating
the different areas.
Tools of Managerial Economics/
Fundamental Principles
Opportunity
cost principle

Equi-
Incremental
marginal
principle
principle

Principle of
Discounting
time
principle
perspective
 1). Opportunity Cost Principle
By the opportunity cost of a decision is meant the sacrifice of alternatives
required by that decision.
The cost involved in any decision consists of the sacrifices of alternatives required
by that decision. If there are no sacrifices, there is no cost.
Opportunity Cost Principle is related and applicable on scarce resource. When
there are alternative uses of limited resource available then one should know
which is the best alternative and which is not.
For ex: 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
ventures.
The opportunity cost of the time an entrepreneur devotes to his own business is
the salary he could earn by seeking employment.
Points to remember
• The opportunity costs of a given sum of money can never be zero.
• All decisions which involve choice must involve opportunity cost
calculation.
• Opportunity costs may be real or monetary, implicit or explicit, either
quantifiable or non-quantifiable.
• Opportunity cost concept is directly applicable to manager’s different
decision areas such as Make or Buy decision, Replacement or New
Investment decision etc.
• The accountant never considers opportunity costs, he considers only
explicit costs.
 2). Incremental Principle
• Incremental concept involves estimating the impact of decision alternatives on
costs and revenues, emphasizing the changes in total cost and total revenue
resulting from changes in prices, products and procedures or investments.
• Two basic components:
Incremental cost: it may be defined as the change in total cost resulting from
a particular decision.
Incremental revenue: it may be defined as the change in total revenue
resulting from a particular decision.
Ex: If a firm decides to go for computerization of market information, the
additional revenue it earns will be termed incremental revenue and the extra
cost of setting up computer facilities will be termed incremental cost.
Incremental Principle
According to incremental principle. A decision is obviously profitable
one if:-
• It increases revenue more than cost.
• It decreases some costs to a greater extent.
• It increases some revenue.
An example to understand this better:
Let’s assume, a manufacturing company, ABC Ltd. Has a production unit where
the total cost incurred in making 100 units of a product X is Rs. 2,000. The
company wants to add another product Y for which it incurs some cost in
terms of salary to the additional labour force, raw materials and assuming that
there were no machinery, equipment, etc. added.
Let’s suppose now after adding the new product line it is able to produce 200
units at Rs. 3,500 so the incremental cost is Rs. 1,500.

No. of Units Total Cost (Rs.) Cost per Unit (Rs.)

100 2,000 20.00

200 3,500 17.50
Suppose a new order is estimated to bring in
an additional revenue of Rs. 5,000. The costs
are estimated as under:
Labour Rs. 1,500 If idle capacity is utilized
Material Rs. 2,000 Material Rs. 2,000
Overhead (120% of labour) Rs. 1,800 Labour Rs. 1,000
Selling and overhead Overhead Rs. 500
(20% on Labour and material ) Rs. 700 Total Incremental cost Rs. 3,500
Full cost Rs. 6,000
 3). Principle of time perspective
• Managerial economics are also concerned with short run and long run
effects of decision on revenue as well as costs. The really important
problem in decision making is to maintain the right balance between long
run and the short run consideration.
• According to this principle, a manager/decision maker should give proper
emphasis both to short term and long term impact of his decision.
• Manager always tries to study the impact of decision on variable like price,
cost, revenue etc. with relation of time factor.
• In short run some factors are fixed while others are variable thus production
can be increased by in increasing the quantity of variable factors.
• While in long run all factors of production can become variable. Entry and
exit of seller firms can take place easily.
 4). Discounting principle
• One of the fundamental ideas in economics is that a rupee tomorrow is
worth less than a rupee today.
• Discounting principle explains about the comparison of money value in
present and future time.
• Suppose a person is offered a choice to make between a gift of Rs. 100
today or Rs. 100 next year. Naturally, he will choose Rs. 100 today.
• There are two reasons:
A. The future is uncertain
B. A person invest money to get some interest.
Formula:

PV= FV/(1+r)t
Where FV= Future Value
PV= Present Value
r= Interest rate
t= Time between present and future value
Example:
Suppose the rate of interest is 8%. The face value is Rs. 100. Analyse how much money today will become Rs.
100 one year after?
FV=PV*(1+r)t

100=PV* (1+8%)1
PV=100/1.08=92.59
4). Equi-marginal principle:
• This principle deals with the allocation of the available resources
among the alternative activities and to get maximum satisfaction.
• This principle is also known the principle of maximum satisfaction by
allocating available resources to get optimum benefits.
• According to modern economist this law has been formulated in the
form of law of proportional marginal utility. It states that the consumer
will spend his money-income on different goods in such a way that the
marginal utility of each good is proportional to its price. i.e.
MUx/Px = MUy/Py
MU= Marginal Utility
P= Price
Example: If a farmer decided to crop 4 different items (Wheat, Mangoes, Sugar
and Rice) on his 70 Acres land and with 20 labours then he also decide how he
will allocate his resources on those crop farming. In general all 20 employees
can be divided equally but in reality mangoes farm need less no. of employees,
whereas wheat and other need more number of employees.