Managerial

Economics

What is economics all

about ?
Economics is about

choices and decisions.

Economics is all about

scarcity
Scarcity
Limited resources
What is scare in a country

need not be scare in another.

Using scares resources

Time
Money

Thus economics is about making

choices !

Contd..
Thats the reason why it is

also called the dismal science.

Marginal Analysis
Applied to the last unit of something.
Eg: on repeatedly consuming a product, what

is the benefit received from the last unit

consumed.

Efficiency and
productivity
Efficiency How well you use the

scare resources or inputs

Productivity = output.

Goods
Economic goods
Goods that have some value
Eg: highly specific medicine
Name a universal good?
ENERGY!!

Utility
The want satisfying capacity of a

commodity.
Eventually, all actions are directed
towards achieving maximum utility.

Thus, economics
involves:
Choices and decisions among scares

resources
Human actions
Scarcity
Trade of
Marginal Analysis
Efficiency and productivity
Goods
utility

The three basic questions in

economics
what

goods and services to

be produced?
How to produce these goods
and services?
Who will get these goods and
services?

Branches of Economics
Micro economics
Macro economics

Micro Economics
Micro comes from Greek word
mikros, meaning small
Microeconomics

Study of behavior of individual

households, firms, and
government

Choices they make

Interaction in specific markets

Focuses on individual parts of an

economy, rather than the whole

Micro Economics
Micro economics focuses on the

behaviour of the individual actors on

the economic stage, that is , firms
and individuals and their interaction
in market

Macro Economics
Macro
Macro comes from Greek word,

makros, meaning large

Macroeconomics
Study of the economy as a
whole
Focuses on big picture and
ignores fine details

Macro Economics
Macro economics is the study of the

economic system as a whole.

It includes techniques for analyzing
changes in total output, total
employment, the consumer price index,
the unemployment rate and exports
and imports.
It addresses aggregate levels of these
variables.

Managerial Economics
Manager
A person who directs resources to achieve a

stated goal.
Economics
The science of making decisions in the
presence of scare resources.
Managerial Economics
The study of how to direct scarce resources
in the way that most efficiently achieves a
managerial goal.

Definition of Managerial Economics

Douglas

- Managerial economics is .. the

application of economic principles and

methodologies to the decision-making process
within the firm or organization.
Pappas & Hirschey - Managerial economics

applies economic theory and methods to

business and administrative decision-making.
Salvatore - Managerial economics refers to the

application of economic theory and the tools of

analysis of decision science to examine how an
organisation can achieve its objectives most
effectively.

what is managerial
economics
Howard Davies and Pun-Lee Lam -

It is the application of

economic analysis to
business problems; it has its
origin in theoretical
microeconomics

These definitions cover a number of

diferent approaches
1. Analysis based on the theory

of the firm
2. Analysis based upon

management sciences
3. Analysis based upon industrial

economics

The process of model

building
The steps: hypothetical-deductive approach
make assumptions about behaviour
work out the consequences of those

assumptions
make predictions
test the predictions against the evidence
PREDICTIONS SUPPORTED? The model is
accepted as a good explanation (for the
moment)
PREDICTIONS REFUTED? Go back and re-work
the whole process

Definitions
&
assumptions

Theoretical
analysis

If predictions
not supported by
data, model is
amended or
discarded

Predictions

Predictions
tested
against data

If predictions
borne out by
data, the model
is valid, for
the moment

What is a good model?

It allows us to make predictions and

set hypotheses
The predictions can be tested
against the empirical evidence
The predictions are supported by the
empirical evidence
It is a representation of reality.

Positive vs Normative economics

Positive = way things are.
Normative = way things should

be.

positive Economics
Study of how economy works
Statements about how the

economy works are positive

statements, whether they are
true or not
Accuracy of positive statements
can be tested by looking at the
factsand just the facts

Normative Economics
Study of what should be
Used to make value judgments, identify

problems, and prescribe solutions

Statements that suggest what we
should do about economic facts, are
normative statements
Based on values
Normative statements cannot be proved
or disproved by the facts alone

Why Economists
disagree..
In some cases, the disagreement may be positive

in nature because
Our knowledge of the economy is imperfect
Certain facts are in dispute
In most cases, the disagreement is normative in
nature because
While the facts may not be in dispute
Difering values of economists lead them to
dissimilar conclusions about what should be
done

Decision making and business

The success or failure of a business

depends on the efectiveness of the

decisions taken by the management.

Decision making
Defined
It is the process of selecting a

particular course of actions from

among a number of alternatives .
As applied to business, a choice is
made among alternative ways of
using or allocating scarce resources
to accomplish pre determined
objectives.

Steps in the process of decision

making

Identification
of
alternative
courses of
action

Evaluation of
alternative
courses of
action

Selection
from the
alternative
courses of
action

To
accomplish
predetermin
ed objective
or objectives

Market
Conditions

Economic
Conditions

Factor
Prices

Managerial
Problems

Managerial Decision

Companys
Performance

Market
Conditions

Nature of managerial economics

Spencer and Siegelman point to the

fact that Managerial Economics.. is

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

Chief Characteristics of
Managerial Economics/Nature
Managerial economics is

economic

micro-

in character as it concentrates
only on the study of the firm and not on the
working of the economy.
Managerial economics takes the help of
macro-economics to understand and
adjust to the environment in which the firm
operates.

Contd..
Managerial economics is

normative

rather than positive in character.

conceptual (theory) and

metrical (quantitative techniques).

It is both

The contents of managerial economics are

based mainly on the theory-of firm.

Knowledge of managerial economics helps in
making wise choices.

Scope of managerial
economics
Following aspects constitute its subject matter:Objectives of a business firm
Demand Analysis and Demand Forecasting
Production and Cost
Competition
Pricing and Output
Profit
Investment and Capital Budgeting and
Product Policy, Sales Promotion and Market Strategy.

Fundamental concepts that aid

decisions
In spite of the imperfections in

knowledge and the presence of

uncertainty management must, take
decisions and formulate plans for the
future.

Incremental cost
The two basic concepts in the incremental analysis are :

incremental cost and incremental revenue.

Incremental cost may be defined as the change in total

cost as a result of change in the level of output,

investment, etc

Incremental

Revenue is change in total revenue

resulting from change in level of output , price etc.

Use of Incremental Reasoning

While taking a decision, a manager always determines the

worthiness of a decision on the basis of criterion that the

incremental revenue should exceed incremental cost

The firm gets an order

which can get it an
additional revenue of Rs.
2000. The normal cost
of production of this
order is:

The addition to cost due

to new order is the
following:
Labour

Rs.400

Materials

800

Labour

Rs.600

Overheads

200

Materials

800

Full cost

Rs.1400

Overheads

720

Selling &
280
administrati
on expenses
Full cost

Rs.2400

Firm would earn a net

profit of Rs 2,000 Rs.

1400 = Rs. 600 while at
first it appeared that the
firm would make a loss
of Rs.400 by accepting
the order.

A course of action should be

pursued up to the point where

its incremental benefits equal
its incremental costs.

Opportunity Cost
All economic questions and problems arise

from scarcity. Economics assumes people

do not have the resources to satisfy all of
their wants. Therefore, we must make
choices about how to allocate those
resources. We make decisions about how
to spend our money and use our time.

Trade of
Decisions involve tradeofs. When you

make a choice, you give up an opportunity

to do something else.

The highest-valued alternative you give up

is the opportunity cost of your decision.

Example
Identical twins Amal and Juan graduate with

Bachelors degrees and receive the same job ofer.

Amal passes up the job ofer to pursue a Masters
degree while Juan takes the job ofer and begins
working.

Two years pass and Amal graduates and begins

working. By this time Juan has been promoted to a

position that is comparable to Amals starting
position, and Juans salary has increased to an
amount that is comparable to Amals starting
salary.

So who made the better decision,

Amal or Juan?
In business and in life, every choice we

make comes at a cost since we forgo other

possible alternatives in the process; this
cost whether its money, time,
education, health, et cetera is known as
an opportunity cost. More specifically

Contd
In the example, one could argue that Amal

made the better decision since a Masters degree

would be valuable if both lost their jobs and
found themselves in a competitive job market.
Yet when you look at the situation in terms of
opportunity costs, Amals Masters degree came
at a cost of two years salary. If Amal and Juan
stay on equal career paths from here on out,
Juan ends up making the better decision.
An opportunity cost is the value or benefit of

the next best alternative

Concept of time
perspective
Alfred Marshall introduced the concept of time into

economic analysis.
Economists often make a distinction between short

run and long run.

Short run means that period within which some of

the inputs (called fixed inputs) cannot be altered.

Long run means that all the inputs can be changed.

Economists try to study the effect of policy decisions

on variables like prices, costs, revenue, etc, in the

light of these time distinctions.

Time perspective
Suppose during idle capacity, a firm receives an order

of 15000 units . For which a customer is willing to pay

Rs.3 per unit. The incremental cost is Rs.2 per unit.
In spite of this favorable situation the management
must consider long run impacts
What will be the reaction of other customers?
Will it tarnish the image of the firm etc?
Thus it can be said that a decision should take into

account all aspects connected with the business both

long and short by giving appropriate weight to the most
relevant time periods.

Discounting principle
The concept of discounting future is based on the fundamental

fact that a rupee now is worth more than a rupee earned a year
after.

Unless these returns are discounted to find their present worth,

it is not possible to judge whether or not it is worth undertaking

the investment today.

Illustrations

Suppose a sum of Rs.100 is due after 1 year.

Let the rate of

interest be 10% . We can determine the sum to be invested
now so as to produce the return (R) of Rs.100 at the end of 1
year. The present value of the discounted value of Rs. 100 will
then be,

R
100
V1

Rs.90.90
1 i 1.10
The same reasoning can be used to find the present value of longer
periods. A present value of Rs.100 due two years later would be,
Rs.100 Rs.100 Rs.100
V2

82.64
2
2
1.21
1 i (1.10)
We can thus write the present worth of a stream of income spread over n
years (i.e R 1 , R 2 ...R n )as
R1
R2
R3
Rn
,
,
............,
3
2
(1 i) (1 i ) 1 i
1 i n
The sum of present values for n years would thus be
n
R1
R2
R3
Rn
Rk
V

..........
..,

k
(1 i) (1 i )2 1 i 3
1 i n

i
k 1

The Equi-Marginal Principle

The law of equi-marginal utility states that a

utility maximizing consumer distributes his

consumption expenditure between various goods
and services he/she consumes in such a way that
the marginal utility derived from each unit of
expenditure on various goods and service is the
same.

This principle suggests that available resources

(inputs) should be so allocated between the

alternative options that the marginal productivity
(MP) from the various activities are equalized.

Contd..
According toequi-marginal principle, an

input should be allocated in such a way that

the value added by the last unit is the same in
all cases.

Example
Suppose a firm has 100 units of labour at its

disposal. The firm is engaged in four activities, which

need labour services, viz., A, B, C and D. It can
enhance any one of these activities by adding more
labour but sacrificing in return the cost of other
activities. If the value of the marginal product is
higher in one activity than another, then it should be
assumed that an optimum allocation has not been
attained. Hence it would, be profitable to shift labour
from low marginal value activity to high marginal
value activity, thus increasing the total value of all
products taken together.

Contd..
For example, if the values of certain two

activities are as follows:

Value of marginal product of labour for
activity A = Rs.20 and, for activity B = Rs.30
In this case it will be profitable to shift labour
from A to activity B thereby expanding activity
B and reducing activity A. The optimum will be
reach when the value of the marginal product
is equal in all the four activities or, when in
symbolic terms:
VMPLA= VMPLB= VMPLC= VMPLD

The equimarginal principle states that consumers

will choose a combination of goods to maximise

their total utility. This will occur where
(Marginal Utility of A) = (Marginal utility of B)

(Price of A) (Price of B)
The consumer will consider both the marginal
utility MU of goods and the price.
In efect the consumer is evaluating the MU/price.
This is known as the marginal utility of expenditure
on each item of good.

Example
Unit
1
2
3
4

MU of A
40
32
24

MU of B
22
20
18
16

16
5
8
14
6
0
12
Suppose the price of good A and good B was Rs.1.
Then the optimum combination of goods would be
quantity of 4.
Because at quantity of 4 > 16/1 = 16/1