LESSON 1

Introduction to Economics

As an MBA student you need to study Managerial Economics which is

concerned with decision making by managers. As you all are aware
that the main job of managers is decision making only. Before making
a decision one has to take into accounts so many things. And here
comes the importance of managerial economics.
Meaning of Economics:
Economics can be called as social science dealing with economics
problem and man’s economic behavior. It deals with economic
behavior of man in society in respect of consumption, production;
distribution etc. economics can be called as an unending science.
There are almost as many definitions of economy as there are
economists. We know that definition of subject is to be expected but at
this stage it is more useful to set out few examples of the sort of issues
which concerns professional economists.

Example:
For e.g. most of us want to lead an exciting life i.e. life full of
excitements, adventures etc. but unluckily we do not always have the
resources necessary to do everything we want to do. Therefore choices
have to be made or in the words of economists “individuals have to
decide-----“how to allocate scarce resources in the most effective
ways”.
For this a body of economic principles and concepts has been
developed to explain how people and also business react in this
situation.
Economics provide optimum utilization of scarce resources to achieve
the desired result. It provides the basis for decision making.

Economics can be studied under two heads:

1) Micro Economics
2) Macro Economics

Micro Economics:
It has been defined as that branch where the unit of study is an
individual, firm or household. It studies how individual make their
choices about what to produce, how to produce, and for whom to
produce, and what price to charge. It is also known as the price theory
is the main source of concepts and analytical tools for managerial
decision making.
Various micro-economic concepts such as demand, supply, elasticity of
demand and supply, marginal cost, various market forms, etc. are of
great significance to managerial economics.
Macro Economics:
It’s not only individuals and forms who are faced with having to make
choices. Governments face many such problems. For e.g.
How much to spend on health
How much to spend on services
How much should go in to providing social security benefits.
This is the same type of problem facing all of us in our daily lives but in
different scales.
It studies the economics as a whole. It is aggregative in character and
takes the entire economic as a unit of study. Macro economics helps in
the area of forecasting. It includes National Income, aggregate
consumption, investments, employment etc.

Meaning of managerial economics:

It is another branch in the science of economics. Sometimes it is

interchangeably used with business economics. Managerial economic
is concerned with decision making at the level of firm. It has been
described as an economics applied to decision making. It is viewed as
a special branch of economics bridging the gap between pure
economic theory and managerial practices.
It is defined as application of economic theory and methodology to
decision making process by the management of the business firms. In
it economic theories and concepts are used to solve practical business
problem. It lies on the borderline of economic and management. It
helps in decision making under uncertainty and improves effectiveness
of the organization.
The basic purpose of managerial economic is to show how economic
analysis can be used in formulating business plans.

Definitions of managerial economics:

In the words of Mc Nair and Merriam,” Managerial Economics consists

of use of economic modes of thought to analyze business situation”.

According to Spencer and Seigelman—“it is defined as the integration

of economic theory with business practice for the purpose of
facilitating decision making and forward planning by the
management”.

Economic provides optimum utilization of scarce resource to achieve

the desired result. ME’s purpose is to show how economic analysis can
be used formulating business planning.
Management Decision Problems

Economic Concepts Decision Science

 Managerial
Economics

Optimal Solution to
Managerial Decision Problems

Managerial Economics bridges the gap between purely analytical problems dealt within
economic theory and decision problems faced in real business and thus helps out in
making rational choices to yield maximum return out of minimum efforts and resources
by making the best selection among alternative course of action.

How does managerial economics differ from regular economics?

• There is no difference in the theory; standard economic theory provides the basis
for managerial economics.
• The difference is in the way the economic theory is applied.
• Economics in its broadest sense means what economists do. They provide
solutions to various economic problems (inflation, unemployment etc). The one
main root cause of all economic problems is SCARCITY and managerial
economics is the use of economic analysis to make business decisions involving
the best use of organization’s scarce resources.

Unlimited Wants Limited resources or means

Scarcity

What to produce? How to produce? For whom to produce?

Human wants are virtually unlimited and insatiable and economic resources to satisfy
them are limited which give rise to choices between what to produce, how to produce and
for whom to produce.

MANAGERIAL ECONOMICS = Economics + Decision Science + Business

Management

Managerial economics has evolved by establishing link on integration

between economic theory and decision sciences along with business management in the
theory and practice for the optimal solution to business decision problems. It deals with
 the application of economic principles and methodologies to the decision making
process within the firm, under the given situation.

Chief Characteristics

• Managerial Economics is micro economic in character: This is because the

unit of study is a firm; it is the problem of a business firm which is studied and it does not
deal with the entire economy as a unit of study.

• Managerial Economics largely uses economic concepts and principles:

Managerial Economics largely uses economic concepts and principles.

• Managerial Economics is pragmatic: It avoids difficult abstract issues of

economic theory but involves complications ignored in economic theory to face the
overall situations in which the decisions are made.

• Managerial Economics belongs to normative rather than positive economics:

Positive economics derives useful theories with testable propositions about ‘what is’
and normative economics provides the basis for value judgment on economic
outcomes, ‘what should be’. In other words it is prescriptive rather then descriptive. It
is known as the ‘normative micro economics of the firm.

• Macro Economics is also useful to managerial economics: Macro economics

provides an intelligent understanding of the environment in which the business unit
must operate. This understanding enables a business executive to adjust in the best
possible manner with external forces over which he has no control but which play a
crucial role in the well being of his concern.

Scope of Managerial Economics:

Scope is something which tells us how far a particular subject will go.
As far as Managerial Economic is concerned it is very wide in scope. It
takes into account almost all the problems and areas of manager and
the firm.
ME deals with Demand analysis, Forecasting, Production function, Cost
analysis, Inventory Management, Advertising, Pricing System,
Resource allocation etc.
Following aspects are to be taken into account while knowing the
scope of ME:
1
2 1. Demand analysis and forecasting:
Unless and until knowing the demand for a product how can we think
of producing that product. Therefore demand analysis is something
which is necessary for the production function to happen. Demand
 analysis helps in analyzing the various types of demand which enables
the manager to arrive at reasonable estimates of demand for product
of his company. Managers not only assess the current demand but he
has to take into account the future demand also.

1 2. Production function:
Conversion of inputs into outputs is known as production function. With
limited resources we have to make the alternative uses of this limited
resource. Factor of production called as inputs is combined in a
particular way to get the maximum output. When the price of input
rises the firm is forced to work out a combination of inputs to ensure
the least cost combination.
1
2
3
4 3. Cost analysis:
Cost analysis is helpful in understanding the cost of a particular
product. It takes into account all the costs incurred while producing a
particular product. Under cost analysis we will take into account
determinants of costs, method of estimating costs, the relationship
between cost and output, the forecast of the cost, profit, these terms
are very vital to any firm or business.

1 4. Inventory Management:
What do you mean by the term inventory? Well the actual meaning of
the term inventory is stock. It refers to stock of raw materials which a
firm keeps. Now here the question arises how much of the inventory
is ideal
stock. Both the high inventory and low inventory is not good for the
firm. Managerial economics will use such methods as ABC Analysis,
simple simulation exercises, and some mathematical models, to
minimize inventory cost. It also helps in inventory controlling.

1 5. Advertising:
Advertising is a promotional activity. In advertising while the copy,
illustrations, etc., are the responsibility of those who get it ready for
the press, the problem of cost, the methods of determining the total
advertisement costs and budget, the measuring of the economic
effects of advertising ---- are the problems of the manager.
There’s a vast difference between producing a product and marketing
it.
It is through advertising only that the message about the product
should reach the consumer before he thinks to buy it. Advertising
forms the integral part of decision making and forward planning.

1 6. Pricing system:
Here pricing refers to the pricing of a product. As you all know that
pricing system as a concept was developed by economics and it is
widely used in managerial economics. Pricing is also one of the central
functions of an enterprise. While pricing commodity the cost of
production has to be taken into account, but a complete knowledge of
the price system is quite essential to determine the price. It is also
important to understand how product has to be priced under different
kinds of competition, for different markets.

7. Resource allocation:
Resources are allocated according to the needs only to achieve the
level of optimization.
As we all know that we have scarce resources, and unlimited needs.
We have to make the alternate use of the available resources. For the
allocation of the resources various advanced tools such as linear
programming are used to arrive at the best course of action.

***************

Tools and Technique of Decision Making:

Business decision making is essentially a process of selecting the best

out of alternative opportunities open to the firm. The steps below put
managers analytical ability to test and determine the appropriateness
and validity of decisions in the modern business world.
Following are the various steps in decision making:
• Establish objectives
• Specify the decision problem
• Identify the alternatives
• Evaluate alternatives
• Select the best alternatives
• Implement the decision
• Monitor the performance

Modern business conditions are changing so fast and becoming so

competitive and complex that personal business sense, intuition and
experience alone are not sufficient to make appropriate business
decisions.
It is in this area of decision making that economic theories and tools of
economic analysis contribute a great deal.
Basic economic tools in managerial economics for decision
making:

Economic theory offers a variety of concepts and analytical tools which

can be of considerable assistance to the managers in his decision
making practice. These tools are helpful for managers in solving their
business related problems. These tools are taken as guide in making
decision.

Following are the basic economic tools for decision making:

1) Opportunity cost
2) Incremental principle
3) Principle of the time perspective
4) Discounting principle
5) Equi-marginal principle

1) Opportunity cost principle:

By the opportunity cost of a decision is meant the sacrifice of
alternatives required by
that decision.
For e.g.
a) The opportunity cost of the funds employed in one’s own business
is the interest that
could be earned on those funds if they have been employed in other
ventures.
b) The opportunity cost of using a machine to produce one product is
the earnings
forgone which would have been possible from other products.
c) 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.
1
2) Incremental principle:
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
1) Incremental cost
2) Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if –
a) it increases revenue more than costs
b) it decreases some costs to a greater extent than it increases others
c) it increases some revenues more than it decreases others and
d) it reduces cost more than revenues”
1
3) Principle of Time Perspective
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.
For example,
Suppose there is a firm with a temporary idle capacity. An order for
5000 units comes to management’s attention. The customer is willing
to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The
short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There
fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/-
for the lot)
Analysis:
From the above example the following long run repercussion of the
order is to be taken into account:
1) If the management commits itself with too much of business at
lower price or with a small contribution it will not have sufficient
capacity to take up business with higher contribution.
2) If the other customers come to know about this low price, they may
demand a similar low price. Such customers may complain of being
treated unfairly and feel discriminated against.
In the above example it is therefore important to give due consideration to
the time perspectives. “a decision should take into account both the short
run and long run effects on revenues and costs and maintain the right
balance between long run and short run perspective”.

4) Discounting Principle:
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-
i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if
the present opportunity is not availed of
ii) 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

5) Equi - marginal Principle:

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.
Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in
four activities which need labors services, viz, A,B,C and D. it can enhance
any one of these activities by adding more labor but only at the cost of other
activities.

Relationship between managerial economic, economic, and other

subjects:

Economic and managerial economics:

Economics contributes a great deal towards the performance of managerial
duties and responsibilities. Just as the biology contributes to the medical
profession and physics to engineering, economics contributes to the
managerial profession. All other qualifications being same, managers with
working knowledge of economics can perform their function more efficiently
than those without it. What is the basic function of the managers of the
business? As you all know that the basic function of the manager of the firm
is to achieve the organizational objectives to the maximum possible extent
with the limited resources placed at their disposal. Economics contributes a
lot to the managerial economics.

Mathematics and managerial economics:

Mathematics in ME has an important role to play. Businessmen deal primarily
with concepts that are essentially quantitative in nature e.g. demand, price,
cost, wages etc. The use of mathematical logic I the analysis of economic
variable provides not only clarity of concepts but also a logical and
systematical framework.

Statistics and managerial economics:

Statistical tools are a great aid in business decision making. Statistical
techniques are used in collecting processing and analyzing business data,
testing and validity of economics laws with the real economic phenomenon
before they are applied to business analysis. The statistical tools for e.g.
theory of probability, forecasting techniques, and regression analysis help
the decision makers in predicting the future course of economic events and
probable outcome of their business decision. Statistics is important to
managerial economics in several ways. ME calls for marshalling of
quantitative data and reaching useful measures of appropriate relationship
involves in decision making. In order to base its price decision on demand
and cost consideration, a firm should have statistically derived or calculated
demand and cost function.

Operations Research and Managerial Economics:

It’s an inter-disciplinary solution finding techniques. It combines economics,
mathematics, and statistics to build models for solving specific business
problems. Linear programming and goal programming are two widely used
OR in business decision making. It has influenced ME through its new
concepts and model for dealing with risks. Though economic theory has
always recognized these factors to decision making in the real world, the
frame work for taking them into account in the context of actual problem has
been operationalised. The significant relationship between ME and OR can be
highlighted with reference to certain important problems of ME which are
solved with the help of OR techniques, like allocation problem, competitive
problem, waiting line problem, and inventory problem.

Management theory and Managerial economics:

As the definition of management says that it’s an art of getting things done
through others. Bet now a day we can define management as doing right
things, at the right time, with the help of right people so that organizational
goals can be achieved. Management theory helps a lot in making decisions.
ME has also been influenced by the developments in the management
theory. The central concept in the theory of firm in micro economic is the
maximization of profits. ME should take note of changes concepts of
managerial principles, concepts, and changing view of enterprises goals.
Accounting and Managerial economics:
There exits a very close link between ME and the concepts and practices of
accounting. Accounting data and statement constitute the language of
business. Gone are the days when accounting was treated as just
bookkeeping. Now its far more behind bookkeeping. Cost and revenue
information and their classification are influenced considerably by the
accounting profession. As a student of MBA you should be familiar with
generation, interpretation, and use of accounting data. The focus of
accounting within the enterprise is fast changing from the concept of
bookkeeping to that of managerial decision making. Mathematics is closely
related to ME. Certain mathematical tools such as logarithm and exponential,
vectors, determinants and matrix algebra and calculus etc.

********************