EE&FA Unit 1

Engineering Economics & Financial Analysis (MG 2452)

INTRODUCTION
Managerial Economics
Relationship with other disciplines
Firms: types, objectives and goals
Managerial decisions
Decision analysis

Economics and Finance are the language of business. An understanding of both these disciplines help
engineers to be more effective in their jobs as they rise up in their organization and shoulder higher
responsibilities.
Every decision in an organization has a financial implications and every organization operates within a system.
An understanding of how the system works helps a person managing an organization to take informed decisions.
When people want to communicate ideas they use language. Language is a medium of exchange. Without
language people are reduced to physical touching or hand signals and have to be physically present with each
other to communicate. With language people can exchange ideas with others in different centuries through
books and in faraway places through the internet, newspapers and telephones. Sharing ideas leads to
increasingly complex social agreements, concepts, inventions and discoveries, raising the standard of living and
the level of expertise for the whole society.
When people want to exchange goods they use money. Money is a medium of exchange. Without money the
marketplace is limited. People are reduced to barter and have to be physically present with each other to
exchange goods. The choice of goods is limited to what is physically available and valued in the moment ~ one
cow for one cart, one tomato for two eggs, three pieces of cloth for one shovel.
With money the choice of goods expands to include everything that is available in all places in the present and
future. The marketplace of goods, opportunity and choice is as diverse as human expression.

What is economics?
Economics is the study of how human beings in a society go about achieving their wants and desires. It
studies how wealth (money) is produced with limited resources in order to satisfy human wants. It is also
defined as the study of allocation of scarce resources to satisfy individual wants or desires.

One standard definition for economics is the study of the production, distribution, and consumption of goods and
services. A second definition is the study of choice related to the allocation of scarce resources.
The first definition indicates that economics includes any business, nonprofit organization, or administrative unit.
The second definition establishes that economics is at the core of what managers of these organizations do.
Economics is a social science. Its basic function is to study how people, individual households, firms and nations
maximize their gains from their limited resources and opportunities.
In economic terminology it is called as maximizing behaviour or more appropriately optimizing behaviour.
Optimizing means selecting best out of available resources with the objective of maximizing gains from given
resources.
The term economics is derived from two Greek words OIKOS (a house) and NEMEIN (to manage).
Economics is the science which studies human behaviour as a relationship between ends and scarce means which
have alternative uses Lionel Robbins
Economics is a social science concerned chiefly with the way society chooses to employ its resources. Which have
alternative uses, to produce goods and services for present and future consumption Samuelson

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Scarcity and uncertainty are the two foundation stones of economics.

Anything which commands a price is a scarce item, called an economic good, and the rest are free goods.
A commodity which is free good today in a particular society might become an economic good tomorrow in the same
society or might even be an economic good today in some other society. For example, water which was a free good,
has a price tag now in many cities but it is still a free good in most rural areas.

What is Positive and Normative Economics?

Positive economics can be defined as a body of systematized knowledge concerning what is; while normative
economics tries to develop criteria for what ought to be. Positive economics is mainly concerned with the
description of economic events and it tries to formulate theories to explain them. But in normative economics, we
give more importance to ethical judgments. Normative economics is concerned with the ideal rather than the
actual situation.
In simple terms, positive analysis is what it is and normative analysis is what it should be. For example, CEOs
in private Indian enterprises earn 15 times as much as the lowest paid employee is a positive statement, a
description of what is. A normative statement would be that CEOs should be paid 4-5 times the lowest paid
employee.

Importance of the study of economics.

The knowledge of economics helps in solving many problems.

The knowledge of economics is essential to conquer (overcome a problem) poverty of the millions of
people and to raise their standard of living.

It explains the relationship between the producer and consumer, the labour and the management.

It gives the businessmen and industrialists the knowledge of modern methods.

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By studying economics we can discover new factors that may lead to increase the national wealth.
Without the knowledge of economics, this is absolutely impossible.

The knowledge of economics is very essential for the finance minister.

a) It helps in framing the system of taxation.
b) It helps in formulating the budget for development.
c) It helps in removing unemployment.

Supply of money, effective credit system, effective working of the banking system can be analysed in
the country only by having a thorough knowledge of economics by the people who admire these
sectors.

Micro Economics

The term mikros in Greek means small. Micro economics refers to the study of small units. In other
words, micro economics studies the individual parts or components of the whole economy.

Micro- economics is the study of particular firms, particular households, individual prices, wages,
income, individual industries and so on.

Micro economics as the name implies is concerned with parts of the economy rather than with the
economy as a whole.

Importance of micro economics

It explains how the market economy operates.

It explains the method or manner in which scarce resources are allocated for different uses.

It explains how goods and services are produced and distributed to the people.

Areas covered by micro economics are

a) Theory of product pricing
b) Theory of factor pricing (rent, wages, interest and profits)
c) Theory of economic welfare (happiness and safety).

Limitations of micro economics

It may not give an idea about the functioning of the whole economy.

The results of micro economics studies may not be applicable to aggregates (total or whole).

It fails to give correct guidance to government to formulate economic policies.

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Macro economics

The term macros in Greek means large. Macro economics is the study of aggregates (total or whole).

It studies about aggregate (total) demand, aggregate consumption, aggregate production, aggregate
income and aggregate investment, etc.

It studies all parts or components of the whole economy and it is not concerned with individual aspects
of the economy.

Macro economics examines the forest and not the trees.

Macro economics deals

a) not with individual quantities but with aggregate of these quantities,
b) not with individual income but with national income,
c) not with individual outputs but with total outputs.

Importance of macro economics

It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic.

It deals with many economic problems such as unemployment, inflation, depression (make very
unhappy, push down or make less active) & recession (a temporary decline or loss in economic
activity).

It is used as a tool to analyse the level of employment, level of prices, etc.

It is useful for the government in formulating suitable economic policies regarding general price level,
wages, etc.

It is only through macroeconomic approach the problems of economic growth could be solved.

All nations, particularly developing nations are eager to increase their national income within the
concern of macro economics.

Areas covered by macro economics are

a) Theory of income, output and employment.
b) Theory of prices
c) Theory of economic growth
d) Theory of distribution.

Limitations of macro economics

Macro analysis cannot be precise because it deals with aggregates (total) which are divergent
(avoiding common assumptions in making deductions) in nature.
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In aggregative (total) thinking the elements have to be chosen carefully. (For e.g.) adding all fruits
together is a meaningful aggregate. Adding fruits with other machinery is an absurd (unreasonable)
aggregate. (i.e.) apple+ bike

Macro analysis may reveal (make known) that the national income of the country has increased by
50%, but the real fact will be that a good majority of people will be living in poverty.

Composition of aggregates may be imperfect in macro analysis. (e.g.) Prices of many commodities
would have fallen in the economy, but the prices of very essential (necessary) commodities might have
risen many times.

The limitations of macro analysis are in the nature of practical difficulties rather than inherent
weakness.

Macro economic policy

Macroeconomic policy can be defined as a programme of action undertaken to control, regulate and
manipulate macro economic variables to achieve the macroeconomic goals of the society
Macro economics is, thus, a policy oriented subject. It deals with a number of policies of macro nature
to solve many issues & problems.
A macroeconomic policy is, in fact an instrument of policing the economy to achieve certain economic
goal.
Macroeconomic policies have macroeconomic goals to fulfill.
The macroeconomic goals include
1. Price stability
2. Economic stability
3. Exchange rate stability
4. Maintenance of full employment
5. Economic growth
6. Economic justice (law)
7. Improvement of standard of living
8. Eradication of poverty
9. Equilibrium in the balance of payments
10. Equitable distribution of national income (or) economic equity
There are number of macro economic policies
1. Monetary policy
2. Fiscal policy
3. Income policy
4. Trade policy
5. Industrial policy
6. Import- Export policy
7. Banking policy
8. Planning policy.
Objective of macroeconomic policy in India
1. Achieving a growth rate of 5- 6 % per annum.
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2. Creating job opportunities for unemployed & underemployed ( not having sufficient demanding
paid work)
3. Removing economic disparity ( differences)
4. Eradication of poverty
5. Controlling inflation & price stabilization
6. Preventing balance of payments imbalances.
Macro economic theories
Macro economic theories provide explanation to inter relationship among different macro economic
variables & issues relating to the problems.
There are number of macro economic theories
1. Theory of income & employment
2. Theory of general price level
3. Theory of distribution
4. Theory of consumption function
5. Theory of investment
6. Theories of trade cycles
7. Theories of economic growth
8. Theories of inflation
9. Theories of monetary policy
10. Theories of fiscal policy
Macro economic variables
Variables- (often changing)
These are macro-economic variables
1. National income (total income of the country is called national income)
a) National product (it consists of all goods and services produced by the community (a group
of people living together in a place) or firm and exchanged for money during a year).
b) National dividend / income (a sum of money paid to a shareholder out of its profit, it consists
of all the incomes, in cash and kind)
c) National expenditure (the total spending or outlay of the firm or community (a group of
people living together in a place) on goods and services produced during a given year).
2. Concept of employment
3. Consumption (it refers to total consumption of the household sector and firms)
4. Savings (it refers to savings of the community or firms as a whole)
Savings = Total income total consumption
5. Investment (total investment of the firms)
6. Government expenditure (government sector spends on consumption and investment)
7. Households (household sector includes all consuming)
8. Firms (firm sector includes all producing)
9. Economic sector (the entire economy is subdivided into four major sector)
a) Primary (agricultural)
b) Secondary (industries and manufacturing activities)
c) Tertiary (services, such as professions banking, trade etc. activities)
d) Foreign or external (refers to rest of the world, international trade)
10. Price level (price of goods in general)
11. Aggregate demand (demand for all goods and services)
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12. Aggregate supply (supply of all goods and services in general)

What is Managerial Economics?

Despite remarkable technological advances during the past several decades, most major engineering decisions
are based on economic considerations-a situation that is unlikely to change in the years ahead. Hence the
importance of economic principles to all engineering students, regardless of their particular disciplinary interests.
A close relationship between management and economics has led to the development of managerial economics.
Management is the guidance, leadership and control of the efforts of a group of people towards some common
objective.
Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial
Economics.
Managerial economics is a discipline which deals with the application of economic theory to business
management. It deals with the use of economic concepts and principles of business decision making.

Define Managerial Economics

Managerial Economics is economics applied in decision making. It is a special branch of economics
bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul.
Business Economics (Managerial Economics) is the integration of economic theory with business practice
for the purpose of facilitating decision making and forward planning by management. Spencer and
Seegelman.
Managerial economics is concerned with application of economic concepts and economic analysis to the
problems of formulating rational managerial decision. Mansfield
A common thread runs through all these descriptions of managerial economics which is using a framework of
analysis to arrive at informed decisions to maximize the firms objectives, often in an environment of uncertainty. It is
important to recognize that decisions taken while employing a framework of analysis are likely to be more successful
than decisions that are knee jerk or gut feel decisions.

Nature of Managerial Economics:

The primary function of management executive in a business organisation is decision making and
forward planning.

Decision making and forward planning go hand in hand with each other. Decision making means
the process of selecting one action from two or more alternative courses of action. Forward
planning means establishing plans for the future to carry out the decision so taken.

The problem of choice arises because resources at the disposal of a business unit (land, labour,
capital, and managerial capacity) are limited and the firm has to make the most profitable use of
these resources.

The decision making function is that of the business executive, he takes the decision which will
ensure the most efficient means of attaining a desired objective, say profit maximisation . After
taking the decision about the particular output, pricing, capital, raw-materials and power etc., are
prepared. Forward planning and decision-making thus go on at the same time.
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A business managers task is made difficult by the uncertainty which surrounds business decisionmaking. Nobody can predict the future course of business conditions. He prepares the best
possible plans for the future depending on past experience and future outlook and yet he has to go
on revising his plans in the light of new experience to minimise the failure. Managers are thus
engaged in a continuous process of decision-making through an uncertain future and the overall
problem confronting them is one of adjusting to uncertainty.

In fulfilling the function of decision-making in an uncertainty framework, economic theory can be,
pressed into service with considerable advantage as it deals with a number of concepts and
principles which can be used to solve or at least throw some light upon the problems of business
management. E.g are profit, demand, cost, pricing, production, competition, business cycles,
national income etc. The way economic analysis can be used towards solving business problems,
constitutes the subject-matter of Managerial Economics.

Thus in brief we can say that Managerial Economics is both a science and an art.

The basic characteristics of managerial economics can now be enumerated as:

It is concerned with decision making of an economic nature.
It is micro-economic in character.
It largely uses that body of economic concepts and principles, which is known as theory of the firm.
It is goal oriented and prescriptive
Managerial economics is both conceptual and metrical. It includes theory with measurement.

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study like
1. Microeconomic Theory: As stated in the introduction, the roots of managerial economics spring from
micro-economic theory. Price theory, demand concepts and theories of market structure are few elements of
micro economics used by managerial economists. It has an applied bias as it applies economic theories in
order to solve real world problems of enterprises.
2. Macroeconomic Theory: This field has little relevance for managerial economics but at least one part of it
is incorporated in managerial economics i.e. national income forecasting. The latter could be an important
aid to business condition analysis, which in turn could be a valuable input for forecasting the demand for
specific product groups.
3. Operations Research: This field is used in managerial economics to find out the best of all possibilities.
Linear programming is a great aid in decision making in business and industry as it can help in solving
problems like determination of facilities on machine scheduling, distribution of commodities and optimum
product mix etc.
4. Theory of Decision Making: Decision theory has been developed to deal with problems of choice or
decision making under uncertainty, where the applicability of figures required for the utility calculus are not
available. Economic theory is based on assumptions of a single goal whereas decision theory breaks new
grounds by recognizing multiplicity of goals and persuasiveness of uncertainty in the real world of
management.
5. Statistics: Statistics helps in empirical testing of theory. With its help, better decisions relating to demand
and cost functions, production, sales or distribution are taken. Managerial economics is heavily dependent
on statistical methods.
6. Management Theory and Accounting: Maximisation of profit has been regarded as a central concept in
the theory of the firm in microeconomics. In recent years, organisation theorists have talked about
satisficing instead of maximising as an objective of the enterprise. Accounting data and statements
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constitute the language of business. In fact the link is so close that managerial accounting has developed
as a separate and specialized field in itself.

Recently, managerial economists have started making increased use of Operation Research methods like
Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be
regarded as part of Managerial Economics.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then
the following fields may be said to generally fall under Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
These divisions of business economics constitute its subject matter.
1. Demand Analysis and Forecasting: A business firm is an economic organisation which is
engaged in transforming productive resources into goods that are to be sold in the market. A major
part of managerial decision making depends on accurate estimates of demand. A forecast of future
sales serves as a guide to management for preparing production schedules and employing
resources. It will help management to maintain or strengthen its market position and profit base.
Demand analysis also identifies a number of other factors influencing the demand for a product.
Demand analysis and forecasting occupies a strategic place in Managerial Economics.
2. Cost and production analysis: A firms profitability depends much on its cost of production. A wise
manager would prepare cost estimates of a range of output, identify the factors causing are cause
variations in cost estimates and choose the cost-minimising output level, taking also into
consideration the degree of uncertainty in production and cost calculations. Production processes
are under the charge of engineers but the business manager is supposed to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing
practices depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and
cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The important
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aspects dealt with this area are: Price determination in various market forms, pricing methods,
differential pricing, product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is one
who can form more or less correct estimates of costs and revenues likely to accrue to the firm at
different levels of output. The more successful a manager is in reducing uncertainty, the higher are
the profits earned by him. In fact, profit-planning and profit measurement constitute the most
challenging area of Managerial Economics.
5. Capital management: The problems relating to firms capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital expenditure
because it involves a large sum and moreover the problems in disposing the capital assets off are
so complex that they require considerable time and labour. The main topics dealt with under capital
management are cost of capital, rate of return and selection of projects.

Finance:
Financial Accounting is primarily concerned with record-keeping directed towards the preparation of profit
and loss account and the balance sheet. The main purposes of financial accounting are:
a) Recording of the transactions concerning and affecting the business
b) Preparation of necessary accounts and balance sheet as required by statutes; and
c) Appraising the owners of the business about the results of the business over a period of time.
Meaning of Finance:
Financial Management deals with the procurement of funds and their effective utilization in the business. The first
basic function of financial management is procurement of funds and the other is their effective utilization.
(i) Procurement of funds: Funds can be procured from different sources; their procurement is a complex problem for
business concerns. Funds procured from different sources have different characteristics in terms of risk, cost and
control.
(ii) Effective utilisation of funds: Since all the funds are procured at a certain cost, therefore it is necessary for the
finance manager to take appropriate and timely actions so that the funds do not remain idle. If these funds are not
utilised in the manner so that they generate an income higher than the cost of procuring them then there is no point in
running the business.
FI NANCE FUNC TI O N
MO NE Y
MA NAG E ME NT

RE CO RD
KE EP I NG &
REP O RTI NG

CO NTRO L
Te c hni que s

A DV I S O RY
RO L E

S ys te ms

(A CCO UNTI NG )
Re sou rce
mo b iliza t ion

Fin an cia l
A ccou n t in g

B ud ge t s

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Re sp on sib ilit y
Cen t re

P ricin g

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Wo rkin g
Ca p ita l
Ma na g e me n t
I n ve st me nt
Ma na g e me n t

Co st
A ccou n t in g
Ma na g e me n t
A ccou n t in g

Co st Co n t ro l

P ro f it Cen t re

I n te rn a l
A ud it

Co st Ce nt re

Divid e nd
P o licy
Va lu a t ion

In ve st men t
Cen t re

Koontz and ODonell define management as the creation and maintenance of an internal environment in an
enterprise where individuals, working together in groups, can perform efficiently and effectively towards the
attainment of group goals. Thus, management is:
Coordination
An activity or an ongoing process
A purposive process
An art of getting things done by other people
On the other hand, economics as stated above is engaged in analysing and providing answers to manifestations of
the most fundamental problem of scarcity. Scarcity of resources results from two fundamental facts of life:
Human wants are virtually unlimited and insatiable, and
Economic resources to satisfy these human demands are limited.
Thus, we cannot have everything we want; we must make choices broadly in regard to the following:
What to produce?
How to produce? and
For whom to produce?

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Firms: types, objectives and goals

What is a firm?
The concept of a firm plays a central role in the theory and practice of managerial economics.
A firm is understood as an organization which converts inputs, which it hires, into outputs, which it sells. The
inputs, called the factors of production (FOP) are classified as follows:

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Four Factors of Production:

In economic terms, the four factors of production are referred to as land, labour, capital (man-made) and
entrepreneur (organization) and the remuneration they receive as rent, wage, interest (capital rental) and
profit respectively
Under human resources, labour input includes both Physical and mental labour, i.e. both unskilled (blue
collar) and skilled (white collar) labour and it is that part of human effort in an organization which is paid
wages and salaries as remuneration. The other kind of human resource is entrepreneurial resource. An
entrepreneur takes the initiative, coordinates, innovates and takes risk and receives as compensation profits
or loss.
Under land resource, land resource has a rather broad meaning in economics it includes all the resources
created (gifted) by God. Thus, it consists of the barren land, minerals, forests, rivers, sea, mountains, etc. as
initially discovered by mankind Any development work which mankind has carried over all these is part of
man made capital. It includes all construction on land, like roads, bridges and buildings (residential as well
as commercial). All the equipments such as plant, machines, tools and inventories which consist of unsold
finished, semi-finished goods and raw materials..
The function of the firm, thus, is to purchase resources or inputs of labour services, capital and raw
materials in order to convert them into goods and services for sale.
There is a circular flow of economic activity between individuals and firms as they are highly interdependent.
Labour has no value in the market unless there is a firm willing to pay for it. In the same way, firms cannot
rationalise production unless some consumer is willing to buy their products. However, there is some
incentive for each. Firms earn profits in turn satisfying the consumption demand of individuals and resource
owners get wage, rent and interest payment. In the process of supplying the goods and services that
consumers demand, firms provide employment to workers and also pay taxes that government uses to
provide service (education, defense) that firms could not provide at all or as efficiently.
Essentially a firm exists because the total cost of production of output is lower than if the firm did not exist.
There are several reasons for lower costs.
The firm changes hired inputs into saleable output. An input is defined as anything that the firm uses in its
production process. Most firms require a wide array of inputs. For example, some of the inputs used by
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major steel firms like SAIL or TISCO are iron ore, coal, oxygen, skilled labour of various types, the services
of blast furnaces, electric furnaces, and rolling mills as well as the services of the people managing the
companies.

Types of Business Organisation

An organizations structure is defined by its configuration and interrelationships of positions and departments.
The organizational design of a company reflects its efforts to respond to changes, integrate new elements,
ensure collaboration, and allow flexibility.
In the past, organizations were commonly structured as bureaucracies. A bureaucracy is a form of organization
based on logic, order, and the legitimate use of formal authority. Bureaucracies are meant to be orderly, fair, and
highly efficient. Their features include a clear-cut division of labor, strict hierarchy of authority, formal rules and
procedures, and promotion based on competency.
Today, many people view bureaucracies negatively and recognize that bureaucracies have their limits. If
organizations rely too much on rules and procedures, they become unwieldy and too rigidmaking them slow to
respond to changing environments and more likely to perish in the long run.

Firms are classified into different categories as follows:

a) Private sector firms.
b) Public sector firms.
c) Joint sector firms.
d) Non-profit firms.

Firms can also be classified on the basis of number of owners as:

a) Proprietorship.
b) Partnership.
c) Corporations.
Some firms mentioned below are different from above. They may provide service to a group of clients for
example, patients or to a group of its members only.
a) Universities.
b) Public Libraries.
c) Hospitals.
d) Museums.
e) Churches.
f) Voluntary Organisations.
g) Cooperatives.
h) Unions.
i) Professional Societies, etc.

Type of Business Organization

A Sole Proprietorship consists of one
individual doing business. Sole
Proprietorships
The vast majority of small businesses start
out as sole proprietorships . . . very
dangerous. These firms are owned by one
person, usually the individual who has day-

ADVANTAGES

DISADVANTAGES

1. Sole proprietors are in

complete control, within the
law, to make all decisions.

1. Unlimited liability and are

legally responsible for all
debts against the business.

2. Sole proprietors receive all

income generated by the

2. Their business and personal

assets are 100% at risk.

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Type of Business Organization
to-day responsibility for running the
business. Sole proprietors own all the assets
of the business and the profits generated by
it. They also assume "complete personal"
responsibility for all of its liabilities or debts.
In the eyes of the law, you are one in the
same with the business.

ADVANTAGES
business to keep or reinvest.
3. Profits from the business
flow-through directly to the
owner's personal tax return.
4. The business is easy to
dissolve, if desired.

DISADVANTAGES
3. Have almost the ability to
raise investment funds.
4. Are limited to using funds
from personal savings or
consumer loans.
5. Have a hard time attracting
high-caliber employees, or
those that are motivated by
the opportunity to own a part
of the business.
6. Employee benefits such as
owner's medical insurance
premiums are not directly
deductible from business
income (partially deductible
as an adjustment to income).

A Partnership is made up of two or more

individuals doing business together.
Partnerships
In a Partnership, two or more people share
ownership of a single business. Like
proprietorships, the law does not distinguish
between the business and its owners. The
Partners should have a legal agreement that sets
forth how decisions will be made, profits will be
shared, disputes will be resolved, how future
partners will be admitted to the partnership, how
partners can be bought out, or what steps will be
taken to dissolve the partnership when needed.
Yes, its hard to think about a "break-up" when
the business is just getting started, but many
partnerships split up at crisis times and unless
there is a defined process, there will be even
greater problems. They also must decide up front
how much time and capital each will contribute,
etc.
Types of Partnerships that should be considered:

General Partnership
Partners divide responsibility for
management and liability, as well as the
shares of profit or loss according to their
internal agreement. Equal shares are
assumed unless there is a written

1. Partnerships are relatively

easy to establish; however
time should be invested in
developing the partnership
agreement.
2. With more than one owner,
the ability to raise funds may
be increased.
3. The profits from the
business flow directly
through to the partners'
personal taxes.
Prospective employees may be
attracted to the business if given
the incentive to become a
partner.

15

1. Partners are jointly and

individually liable for the
actions of the other partners.
2. Profits must be shared with
others.
3. Since decisions are shared,
disagreements can occur.
4. Some employee benefits are
not deductible from business
income on tax returns.
5. The partnership has a
limited life; it may end upon
a partner withdrawal or
death.

EE&FA Unit 1
Type of Business Organization
agreement that states differently.
Limited Partnership and Partnership with
limited liability
"Limited" means that most of the partners
have limited liability (to the extent of their
investment) as well as limited input
regarding management decisions, which
generally encourages investors for short
term projects, or for investing in capital
assets. This form of ownership is not often
used for operating retail or service
businesses. Forming a limited partnership is
more complex and formal than that of a
general partnership.
A corporation, chartered by the state in
which it is headquartered, is considered by I.
law to be a unique "entity", separate and
apart from those who own it. A corporation
can be taxed; it can be sued; it can enter
into contractual agreements. The owners of
II.
a corporation are its shareholders. The
shareholders elect a board of directors to
oversee the major policies and decisions.
The corporation has a life of its own and
does not dissolve when ownership changes.

ADVANTAGES

DISADVANTAGES

Shareholders have limited

liability for the corporation's
debts or judgments against
the corporations.

1. The process of incorporation

requires more time and
money than other forms of
organization.

Generally, shareholders can

only be held accountable for
their investment in stock of
the company. (Note
however, that officers can be
held personally liable for
their actions, such as the
failure to withhold and pay
employment taxes.)

2. Corporations are monitored

by federal, state and some
local agencies, and as a
result may have more
paperwork to comply with
regulations.

III.

Corporations can raise

additional funds through the
sale of stock.

IV.

A corporation may deduct

the cost of benefits it
provides to officers and
employees.
Can elect S corporation
status if certain
requirements are met. This
election enables company to
be taxed similar to a
partnership.
16

3. Incorporating may result in

higher overall taxes.
Dividends paid to
shareholders are not
deductible from business
income, thus this income
can be taxed twice.

EE&FA Unit 1

OBJECTIVE OF THE FIRM

The traditional objective of the firm has been profit maximisation. We define profits as revenues less costs. But the
definition of cost is quite different for the economist than for an accountant.
This accounting or business profit is what is reported in publications and in the quarterly and annual financial reports
of businesses. The economist recognises other costs, defined as implicit costs. These costs are not reflected in cash
outlays by the firm, but are the costs associated with foregone opportunities. Such implicit costs are not included in
the accounting statements but must be included in any rational decision making framework.
The economic profit equals the revenue of the firm minus its explicit costs and implicit costs. To arrive at the cost
incurred by a firm, a value must be put to all the inputs used by the firm. Money outlays are only a part of the costs.
As stated above, economists also define opportunity cost. Since the resources are limited, and have alternative uses,
you must sacrifice the production of a good or service in order to commit the resource to its present use. For
example, if by being the owner manager of your firm, you sacrifice a job that offers you Rs. 2,00,000 per annum, then
two lakhs is your opportunity cost of managing the firm.
The assignment of monetary values to physical inputs is easy in some cases and difficult in others. All economic
costing is governed by the principle of opportunity cost. If the firm maximises profits, it must evaluate its costs
according to the opportunity cost principle. Assigning costs is straightforward when the firm buys an input on a
competitive market. Suppose the firm spends Rs. 20,000 on buying electricity. For its factory, it has sacrificed claims
to whatever else Rs 20,000 can buy and thus the purchase price is a reasonable measure of the opportunity cost of
using that electricity. The situation is the same for hired factors of production.
However, a cost must be assigned to factors of production that the firm neither purchases, nor hires because it
already owns them. The cost of using these inputs is implicit costs and has to be imputed. Implicit costs arise
because the alternative (opportunity) cost doctrine must be applied to be firm. The profit calculated after including
implicit as well as explicit costs in total cost is called economic profit.
Profit plays two primary roles in the free-market system. First, it acts as a signal to producers to increase or decrease
the rate of output, or to enter or leave an industry. Second, profit is a reward for entrepreneurial activity, including risk
taking and innovation. In a competitive industry, economic profits tend to be transitory.
The achievement of high profits by a firm usually results in other firms increasing their output of that product, thus
reducing price and profit. Firms that have monopoly power may be able to earn above-normal profits over a longer
period; such profit does not play a socially useful role in the economy.
FUNDAMENTAL CONCEPTS THAT AID DECISIONS:

i.

Incremental concept

ii.

The concept of time perspective

iii.

The discounting principle

iv.

The concept of opportunity cost

v.

The equi-marginal principle

Incremental concept: Incremental cost and incremental revenue is more or less the same as
Marginal cost and Marginal Revenue but there are slight differences.
17

EE&FA Unit 1

Marginal Revenue is the addition to the total revenue per unit of output change.
Incremental Revenue simply measures the difference between old and new revenues.

IR R2 R1 VR

MR

R2 R1
Q2 Q1

VR
VQ

Suppose a firm manufacturing fountain pens and selling it at a price of Rs. 5 decides to reduce the price to
Rs. 4. As a result sales increase from Rs. 1000 to Rs. 1500 pens. In this case the incremental and marginal
revenues can be calculated as under:

IR = R2 R1= (Rs. 4 X 1500 units) (Rs. 5 X 1000 units) = Rs. 6000 Rs. 5000 = Rs. 1000

MR = (6000-5000)/ (1500-1000) = 1000/500 = Rs. 2

Similarly incremental costs are additional costs incurred due to change in the nature of activity. These costs
refer to any type of change, adding a new product, changing distribution channels, installing a new machine,
expanding the marker area and so on. Incremental measures the difference between old and new costs. On
the other hand, Marginal cost denotes the extra cost incurred in adding a unit of output. It is the per unit cost
of the added units. Marginal cost has limited meaning. Incremental cost is very flexible referring to any kind
of change, while marginal costs are calculated for unit changes in output.

Incremental costs are additional costs due to a change in the nature of activity. These costs refer to any type
of change; adding a new product, changing distribution channels, installing a new machine, expanding the
market area, etc. Incremental cost measures the difference between the old and new total costs. It
measures the impact of decision alternatives on the total costs.

Marginal cost denotes the extra cost incurred in adding a unit of output. It is the per unit cost of the added
units. Marginal cost has limited meaning.

Incremental cost is very flexible referring to any kind of change, while marginal costs are calculated for unit
changes in output.

A manager always determines the worth of a decision on the basis of the criterion that IR>IC.
A decision is profitable if
it increases revenue more than it increases cost
it reduces some costs more than it increases others
it increases some resources more than it decreases others
it decreases costs more than it decreases revenues.

IC C2 C1 VC

MC

C2 C1
Q2 Q1

VC
VQ

18

EE&FA Unit 1

MC and MR are always defined in terms of unit changes in output. But incremental costs and revenues are
not necessarily restricted to unit changes.

The firm is an organisation that produces a good or service for sale and it plays a central role in theory and
practice of Managerial Economics. In contrast to nonprofit institutions like the Ford Foundation, most firms
attempt to make a profit. There are thousands of firms in India producing large amount of goods and
services; the rest are produced by the government and non-profit institutions. It is obvious that a lot of
activities of the Indian economy revolve around firms.

Production is any activity that transforms inputs into output and is applicable not only to the
production of goods like steel and automobiles, but also to production of services like banking and
insurance. Production refers to all activities which are undertaken to produce goods which satisfy human
wants.

The selling price of a product is derived as shown below:

a)
b)
c)
d)
e)
f)
g)

Direct material cost + Direct labour cost + Direct expenses

Prime cost + Factory overhead
Factory cost + Office & Administrative Overhead
Cost of production + Opening finished stock + Closing finished stock
Cost of goods sold + Selling & Distribution overheads
Cost of sales + Profit
Sales / Quantity sold

= PRIME COST
= FACTORY COST
= COST OF PRODUCTION
= COST OF GOODS SOLD
= COST OF SALES
= SALES
= SELLING PRICE PER UNIT

In the above calculations, if the opening stock of finished goods is equal to the closing stock of finished goods, then the
cost of production is equal to the cost of goods sold.

What is Cost?
Ans: Cost refers to the summation of all costs incurred by the firm and revenues refer to the sale proceeds of goods and
services.
TYPES OF COST
FIXED COSTS: The cost incurred in acquiring the fixed assets of the firm, viz. equipment, machinery, land, buildings permanent
staff, etc. These inputs o =r factors of production can be used over a period of time
VARIABLE COSTS: There are other inputs which are exhausted

MARGINAL COST: It is the cost of producing an additional unit of that product. Let the cost of producing 20 units of the
product be Rs. 10,000, and the cost of producing 21 units of the same product be Rs. 10,045. Then the marginal cost of
producing the 21st unit is Rs. 45.
MARGINAL REVENUE: The Marginal Revenue of a product is the incremental revenue of selling an additional unit of that
product. Let the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21 units of the same product be
Rs. 15,085. Then the marginal revenue of selling the 21 st unit is Rs.85.

SUNK COST: This is known as the past cost of an equipment / asset. Let us assume that an equipment has been purchased
for Rs. 1,00,000 about three years back. If it is considered for replacement, then its present value is not Rs. 1,00,000. Instead, its
present market value should be taken as the present value of the equipment for further analysis. So, the purchase value of the
equipment in the past is known as sunk cost.

What is Opportunity Cost?

Ans: OPPORTUNITY COST: Foregone contribution expected from the second best alternative use of resources.

19

EE&FA Unit 1
There is a conceptual difference in approach between an accountant and an economist. As far as revenues are concerned there
is no disagreement, for there can be no dispute about whatever flows in as sale proceeds. But in calculating costs, both the
accountant and the economist use a different approach.
The accountant views the cost of an asset by taking into account the actual money spent on it. In short, it is the actual money
spent in acquiring the same. It is the money spent or acquisition cost. But on the other hand, the economist views the cost in
terms of Opportunity cost i.e. the cost of holding the factor from its alternative use. The economist analyses cost in terms of
choice faced by the firm in utilizing its resources. The opportunity cost may be more than the acquisition cost or it may be less.
In practice if a particular alternative(say X) is selected from a set of competing alternatives (say X, Y) then the corresponding
investment in the selected alternative is not available for any other purpose. If the same money is invested in some other
alternative (Y) it may fetch some return. Since the money has already been invested in the selected alternative X, one has to
forego the return from the other alternative Y. The amount that is foregone by not investing the same money in another
alternative.

What are the objectives of a firm?

Although, profit maximisation is a dominant objective of the firm, other important objectives of the firm, other than
profit maximisation are:
1. Maximisation of sales revenue.
2. Maximisation of firms growth rate
3. Maximisation of managers own utility or satisfaction
4. Making a satisfactory rate of profit.
5. Long-run survival of the firm
6. Entry-prevention and risk avoidance.
ALTERNATIVE OBJECTIVES OF FIRMS
Economists have also examined other objectives of firms. We shall discuss some of them here. According to Baumol,
most managers will try to maximise sales revenue. There are many reasons for this. For example, the salary and
other earnings of managers are more closely related to sales revenue than to profits.
Banks and financers look at sales revenue while financing the corporation. The sales revenue trend is a readily
available indicator of performance of the firm.
Growth in sales increases the competitive strength of the firm. However, in the long run, sales maximisation and profit
maximisation may converge into one objective.
VALUE MAXIMIZATION:
Most firms have sidelined short-term profit as their objective. Firms are often found to sacrifice their short-term profit
for increasing the future long-term profit. Thus, the theory states that the objective of a firm is to maximise wealth or
value of the firm.
The objective of the firm is thus to maximise the present or discounted value of all future profits and can be stated as:

Graphic representation of PV of Annuity of Re.1 @ 10%

Time period

End

of

the

year

Re.1

Re.1

Re.1

Re.1
20

EE&FA Unit 1

Rs.
Rs.
Rs.
Rs.

0.909
0.826
0.751
0.683
-------Total Rs.(PV) 3.169
=====
Present value of a Future Cash Flow (Inflow or Outflow) is the amount of current cash that is of equivalent
value to the decision maker.
Discounting is the process of determining present values of a series of future cash flows.
The Present Value (PV) of Rs. 4 received over a period of 4 years is Rs.3.169 (discounted @10%)
The compound interest rate used for discounting cash flows is called the discount rate

Discounted Cash Flow (DCF) is what someone is willing to pay today in order to receive cash flow of
future years. The DCF method converts future earnings in todays money.
The Future Cash Flows must be recalculated (discounted) to represent their present values. In this way
the value of a company or project under consideration as a whole is determined properly.
The DCF method is an approach for valuation whereby projected cash flows are discounted at an interest
rate (also called the rate of return) that reflects the perceived amount of risk of the cash flows.
In fact the Discount Rate reflects two things:
1. The Time value of money Any investor would prefer to have cash immediately than having to
wait. Therefore, investors must be compensated by paying for the delay.
2. A Risk Premium that represents the extra return which investors demand for the risk that the
cash flow might not materialize.
Whatever product or service a company offers it must meet the customers wants in the most satisfactory manner.
This should be the aim of the company. A company has to continuously upgrade itself on several parameters:
production efficiency, product development, quality management and marketing skills.
This competitiveness - defined by Michael Porter as the sustained ability to generate more value for customers than
the cost of creating that value - is what will keep Indias Companies alive in the bitter battle for survival that they are
waging even on their home turf with rivals pouring in from all corners of the globe.

FIRMS CONSTRAINTS
Decision-making by firms takes place under several restrictions or constraints, such as:
Resource Constraints: Many inputs may be available in a limited or fixed quantity e.g., skilled workers, imported
raw material, etc.
Legal Constraints: Both individuals and firms have to obey the laws of the State as well as local laws.
Environmental laws, employment laws, disposal of wastes are some examples.
21

EE&FA Unit 1
Moral Constraints: These imply to actions that are not illegal but are sufficiently consistent with generally accepted
standards of behaviour.
Contractual Constraints: These bind the firm because of some prior agreement such as a long-term lease on a
building or a contract with a labour union that represents the firms employees.
Decision-making under these constraints with optimal results is a fundamental part of managerial economics.
MARGINAL UTILITY:
In ordinary language utility means usefulness. But in economics utility is defined as the power of a commodity
or a service to satisfy a human want.
Utility is a subjective or psychological concept. Mutton for a vegetarian has no utility. Warm clothes have little
utility for people living in the tropics.
So utility depends on the consumer and the need for the commodity/ service.
Total utility refers to the sum of utilities of all units of a commodity consumed.
Marginal utility is the addition made to the total utility by consuming one more unit of a commodity.
Law of Diminishing Marginal Utility : If a consumer takes more and more units of a commodity, the additional
utility he derives from an extra unit of the commodity goes on falling. Thus the marginal utility decreases with the
increase in the consumption of a commodity. When the marginal utility decreases the Total Utility increases at a
diminishing rate.
Explanation:
Suppose Mr. X is hungry and eats apples one by one. The first apple gives great pleasure (high utility) as he is
hungry. When he takes the second apple, the extent of hunger reduces. Therefore, he will derive less utility from
the second apple. In this way, the additional utility (marginal utility) from the extra unit will go on decreasing. If
the consumer continues to take more apples, the marginal utility falls to zero and becomes negative.
No. of apples Total Utility
Marginal
Utility
1
20
20
2
35
15
3
45
10
4
50
5
5
50
0
6
45
-5
7
35
-10
RELATIONSHIP BETWEEN TOTAL UTILITY & MARGINAL UTIITY
MARGINAL UTILITY
TOTAL UTILITY
Declines
Increases
Reaches Zero

Reaches maximum

Becomes negative

Declines

22

EE&FA Unit 1

THE EQUI-MARGINAL PRINCIPLE

The idea of equi-marginal principle was first mentioned by HH Gossen of Germany, hence it is called Gossens
Second Law.
The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one
commodity.
Consumers wants are unlimited but consumers income available to satisfy the wants is limited.
This law explains how the consumer spends his limited income on various commodities to get maximum
satisfaction
According to this principle, different courses of action should be pursued up to the point where all the courses
provide equal marginal benefit per unit of cost. It states that a rational decision-maker would allocate or hire his
resources in such a way that the ratio of marginal returns and marginal costs of various uses of a given resource
or of various resources in a given use is the same.
This law is also known as the Law of substitution or Law of Maximum satisfaction or Principle of
proportionality between prices and Marginal Utility
Explanation:
Suppose there are two goods X and Y on which a consumer has top spend his limited income. The consumer being
rational he will spend his limited income on goods X and Y to maximize his total utility of satisfaction. Only at that
point the consumer will be in equilibrium.
Symbolically, the consumer will be in equilibrium when:

MU X MUY

MU M
PX
PY
Where:
MUX = Marginal utility of commodity X
PX
= Price of commodity X
MUY = Marginal utility of commodity Y
23

EE&FA Unit 1
PY
MUM

= Price of commodity Y
= Marginal utility of Money

MU X
PX

MU Y
PY
and

are known as Marginal Utility of money expenditure

If a person has a thing which can be put to several uses, he will distribute it among these uses in such a way, that it
has the same Marginal Utility in all Prof. Marshall
The equi-marginal principle can be applied only where:
i.
Firms have limited investible resources
ii.
Resources have alternative uses, and
iii.
The investment in various alternative uses is subject
Managerial decisions
Managerial Economics (ME) serves as a link between traditional economics and the decision making sciences for
business decision making. ME is a systematic way of thinking, approaching, analyzing managerial decisions.
The focus of managerial economics is on how the firm reacts to changes in the economic environment in which it
operates and how it predicts these changes and devises the best possible strategies to achieve the objectives that
underlie its existence.
ME focuses on the prescriptive approach to managerial decision, meaning an applied approach (instead of
theoretical) to analyzing practical decisions actually faced by businesses and governments.
Most of the analytical methods covered in ME were developed in response to important, actual real-world, recurring
managerial decisions, such as optimal pricing (e.g., pricing in the airline industry taking into account consumer
demand, profit maximization, elasticity, rivals reactions), forecasting (Maruti forecasting demand to determine
optimal production, pricing, advertising, etc.), capital budgeting (Price Volume comparison of current costs versus
expected future benefits), cost-benefit analysis of regulation or legislation, etc.
M AN
AG ER
IAL

Traditional
Econom ics

O ptimal solution to
business problems

Decisio
n
Problem
Decision Sciences (Tools
& techniques of analysis)

Decision analysis
24

EE&FA Unit 1

Decision making forms the core of managerial economics.

Decision making is the process of selecting a particular course of action among various alternatives.

Every manager has to work on uncertainties and the future cannot be precisely predicted by anyone.

If everything could be predicted accurately, then decision making would become a very simple process.
Because of the presence of uncertainty, the decision maker must be very careful in choosing a
particular course of action in order to realize the objectives. The result may lead to either nonrealization of objective or complete realization of objective or partial realization of objective.

Decision-making: Meaning and its characteristics

Basic economic tools in managerial economics for 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
process:
1. Establish objectives
2. Specify the decision problem
3. Identify the alternatives
4. Evaluate alternatives
25

EE&FA Unit 1

5. Select the best alternatives

6. Implement the decision
7. Monitor the performance

Decision-making is a process of selection from a set of alternative courses of action, which is thought
to fulfill the objectives of the decision problem more satisfactorily than others.
It is a course of action, which is consciously chosen for achieving a desired result.
A decision is a process that takes place prior to the actual performance of a course of action that has
been chosen. In terms of managerial decision-making, it is an act of choice, wherein a manager selects
a particular course of action from the available alternatives in a given situation.
Managerial decision making process involves establishing of goals, defining tasks, searching for
alternatives and developing plans in order to find the best answer for the decision problem. The
essential elements in a decision making process include the following:
1. The decision maker,
2. The decision problem,
3. The environment in which the decision is to be made,
4. The objectives of the decision maker,
5. The alternative courses of action,
6. The outcomes expected from various alternatives, and
7. The final choice of the alternative.

Characteristics of decision-making:
1. It is a process of choosing a course of action from among the alternative courses of action.
2. It is a human process involving to a great extent the application of intellectual abilities.
3. It is the end process preceded by deliberation and reasoning.
4. It is always related to the environment. A manager may take one decision in a particular set of
circumstances and another in a different set of circumstances.
5. It involves a time dimension and a time lag.
6. It always has a purpose. Keeping this in view, there may just be a decision not to decide.
7. It involves all actions like defining the problem and probing and analyzing the various alternatives,
which take place before a final choice is made.
26

EE&FA Unit 1

Steps in rational decision making

Effective decision-making process requires a rational choice of a course of action.
Rationality is the ability to follow systematically, logical, thorough approach in decision making.
Thus, if a decision is taken after thorough analysis and reasoning and weighing the consequences of
various alternatives, such a decision will be called an objective or rational decision. Therefore
rationality is the ability to follow a systematic, logical and thorough approach in decision-making
process.
Gross suggested three dimensions to determine rationality: (i) the extent to which a given action
satisfies human interests; (ii) feasibility of means to the given end; (iii) consistency.
Steps of decision-making process are given below:
1. Diagnosing and defining the problem: the first step in decision-making is to find out the correct
problem. It is not easy to define the problem. It should be seen what is causing the trouble and
what will be its possible solutions. Before defining a problem, a manager has to identify critical or
strategic factor of the problem. Once the problem is properly defined then it will be easily solved.
So, the first important factor is the determination of the problem.
2. Analysis of problem: after defining a problem, a manager should analyse it. He should collect all
possible information about the problem and then decide whether it will be sufficient to take decision
or not. Sometimes it may be costly to get additional information or further information may not be
possible whatever information is available should be used to analyse the problem. Analyzing the
problem involves classifying the problem and gathering information. Classification is necessary in
order to know who should take the decision and who should be consulted in taking it. Without
proper classification, the effectiveness of the decision may be jeopardized. The problem should be
classified keeping in view the following factors: (i) the nature of the decision, i.e., whether it is
strategic or it is routine. (ii) the impact of the decision on other functions, (iii) the futurity of the
decision, (iv) the periodicity of the decision and (v) the limiting or strategic factor relevant to the
decision.
3. Collection of data: in order to classify any problem, we require lot of information. So long as the
required information is not available, any classification would be misleading. This will also have an
adverse impact on the quality of the decision. Trying to analyse without facts is like guessing
directions at a crossing without reading the highway signboards. Thus, collection of right type of
information is very important in decision-making. It would not be an exaggeration to say that a
decision is as good as the information on which it is based. Collection of facts and figures also
requires certain decisions on the part of the manager. He must decide what type of information he
requires and how he can obtain this. It is also important to note that when one gathers the facts to
analyse a problem, he wants facts that relate to alternative courses of action. So one must know
what the several alternatives are and then should collect information that will help in comparing the
alternatives. Needless to say, collection of information is not sufficient; the manager must also
know how to use it. It is not always possible to get all the information that is needed for defining
and classifying the problem. In such circumstances, a manager has to judge how much risk the
decision involves as well as the degree of precision and rigidity that the proposed course of action
27

EE&FA Unit 1

can afford. It should also be noted that fact finding for the purpose of decision-making should be
solution-oriented. The manager must lay down the various alternatives first and then proceed to
collect fact, which will help in comparing alternatives.
4. Developing alternatives: after defining and analyzing the problem, the next step in the decision
making process is the development of alternative courses of action. Without resorting to the
process of developing alternatives, a manager is likely to be guided by his limited imagination. It is
rare for alternatives to be lacking for any course of action. But sometimes, a manager assumes
that there is only one way of doing a thing. In such a case, what the manager has probably not
done is to force himself decision, which is the best possible. From this can be derived a key
planning principle which may be termed as the principle of alternatives. Alternatives exist for every
decision problem. Effective planning involves a search for the alternatives towards the desired
goal. Once the manager starts developing alternatives, various assumptions come to his mind,
which he can bring to the conscious level. Nevertheless, development of alternatives cannot
provide a person with the imagination, which he lacks. But most of us have definitely more
imagination than we generally use. It should also be noted that development of alternatives is no
guarantee of finding the best possible decision, but it certainly helps in weighing one alternative
against others and, thus, minimizing uncertainties.
5. Review of key factors: while developing alternatives, the principle of limiting factor has to be
taken care of. A limiting factor is one which stands in the way of accomplishing the desired goal. It
is a key factor in decision-making. It such factors are properly identified, manager can confine his
search for alternative to those, which will overcome the limiting factors. In choosing from among
alternatives, the more an individual can recognize those factors which are limiting or critical to the
attainment of the desired goal, the more clearly and accurately he or she can select the most
favourable alternatives. It is not always necessary that the alternatives solutions should lead to
taking some action. To decide to take no action is also a decision as much as to take a specific
action. It is imperative in all organisational problems that the alternative of taking no action is being
considered. For instance, if there is an unnecessary post in the department, the alternative not to
fill it will be the best one. The ability to develop alternatives is often as important as making a right
decision among the alternatives. The development of alternatives, if thorough, will often unearth so
many choices that the manager cannot possibly consider them all. He will have to take the help of
certain mathematical techniques and electronic computers to make a choice among the
alternatives.
6. Selecting the best alternative: in order to make the final choice of the best alternative, one will
have to evaluate all the possible alternatives. There are various ways to evaluate alternatives. The
most common method is through intuition, i.e., choosing a solution that seems to be good at that
time. There is an inherent danger in this process because a managers intuition may be wrong on
several occasions. The second way to choose the best alternative is to weigh the consequences of
one against those of the others.
Peter Drucker has laid down four criteria in order to weigh the consequences of various
alternatives. They are:
(i)

Risk: a manager should weigh the risks of each course of action against the expected
gains. As a matter of fact, risks are involved in all the solution. What matters is the
intensity of different types of risks in various solutions.
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EE&FA Unit 1

(ii)
(iii)

(iv)

Economy of effort: the best manager is one who can mobilize the resources for the
achievement of results with the minimum of efforts. The decision to be chosen should
ensure the maximum possible economy of efforts, money and time.
Situation or timing: the choice of a course of a action will depend upon the situation
prevailing at a particular point of time. If the situation has great urgency, the preferable
course of action is one that alarms the organisation that something important is
happening. If a long and consistent effort is needed, a slow start gathers momentum
approach may be preferable.
Limitation of resources: in choosing among the alternatives, primary attention must
be given to those factors that are limiting or strategic to the decision involved. The
search for limiting factors in decision-making should be a never-ending process.
Discovery of the limiting factor lies at the basis of selection from the alternatives and
these are experience, experimentation and research and analysis which are discussed
as:
(a) Experience: in making a choice, a manager is influenced to a great extent by
his past experience. Sometimes, he may give undue importance to past
experience. He should compare both the situations. However, he can give more
reliance to past experience in case of routine on his past experience to reach at a
rational decision.
(b) Experimentation: under this approach, the manager tests the solution under
actual or simulated conditions. This approach has proved to be of considerable
help in many cases in test marketing of a new product. But it is not always
possible to put this technique into practice, because it is very expensive. It is
utilized as the last resort after all other techniques of decision making have been
tried. It can be utilized on a small scale to test the effectiveness of the decision.
For instance, a company may test a new product in a certain territory before
expanding its scale nationwide.
(c) Research and analysis: it is considered to be the most effective technique of
selecting among alternatives, where a major decision is involved. It involves a
search for relationships among the more critical variables, constraints and
premises that bear upon the goal sought. In a real sense, it is the pencil and paper
approach to decision making. It weighs various alternatives by making models. It
takes the help of computers and certain mathematical techniques. This makes the
choice of the alternative more rational and objective.

7. Putting the decision into practice: the choice of an alternative will not serve any purpose if it not
put into practice. The manager is not only concerned with taking a decision, but also with its
implementation. He should try to ensure that systematic steps are taken to implement the decision.
The main problem whi8ch the manager may face at the implementation stage is the resistance by
the subordinates who are affected by the decision. If the manager is unable to overcome this
resistance, the energy and efforts consumed in decision-making will go waste. In order to make the
decision acceptable. It is necessary for the manager to make the people understand what the
decision involves, what is expected of them and what they should expect from the management.
The principle of slow and steady progress should be followed to bring a change in the behaviour of
the subordinates. In order to make the subordinates committed to the decision, it is essential that
they should be allowed to participate in the decision making process. The managers, who discuss
problems with their subordinates and give them opportunities to ask questions and make
suggestions, find more support for their decisions than the managers who dont let the
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subordinates participate. Now the question arises at what level of the decision making process the
subordinates should participate. The subordinates should not participate at the stage of defining
the problem because the manager himself is not certain as to whom the decision will affect. The
area where the subordinates should participate is the development of alternatives. They should be
encouraged to suggest alternatives. This may bring to surface certain alternatives, which may not
be thought of by the manager. Moreover, they will feel attached to the decision. At the same time,
there is also a danger that a group decision may be poorer than the one-man decision. Group
participation does not necessarily improve the quality of the decision, but sometimes impairs it.
Someone has described group decision like a train in which every passenger has a brake. It has
also been pointed out that all employees are unable to participate in decision-making.
Nevertheless, it is desirable if a manager consults his subordinates while making decision.
Participative management is more successful than the other styles of management. It will help in
the effective implementation of the decision.
8. Follow up: it is better to check the results after putting the decision into practice. The reasons for
the following up of decision are as follows:
(i)
(ii)
(iii)

if the decision is good one, one will know what to do, if faced with the similar problem
again.
If the decision is bad one, one will know what not to do, the next time.
If the decision is bad and one follows up soon enough, corrective action may still be
possible. In order to achieve proper follow up, the management should devise an
efficient system of feedback information. This information will be very useful in taking
the corrective measures and in taking right decisions in the future.

Basic economic tools in managerial economics for 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
process:
1. Establish objectives
2. Specify the decision problem
3. Identify the alternatives
4. Evaluate alternatives
5. Select the best alternatives
6. Implement the decision
7. 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
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is in this area of decision making that economic theories and tools of economic analysis contribute a great
deal.

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