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Managerial economic 1.

Introduction to Economics - Every

field has its own language. To study M.E you have to think in terms of Economics. Every field has its own language. To study M.E you have to think in terms of Economics.

2. Ten Principles divided into three Subs segments

1. How People make decisions 2. How People interact 3. How the Economy as a whole works
(a) People face Trade offs (b) The cost of something is what you give up to get it better off depends on its ability to produce (c) Rational people think at organize Economic activity (d) People respond to incentives (e) Trade can make every one

(f) Markets are a good way to get Goods and Services, the Margin MC = MB (g) Governments can sometimes faces a shortrun Trade off (h) A countrys standard of living (I) Prices rise when the Government prints too much money (j) Society

Concepts introduced: Trade offs between

alternative goals Inflation and unemployment Efficiency and Equity Technology and unemployment Work and leisure ratio Saving and Consumption

Opportunity cost - limited resources having

alternative uses. Problem of Scarcity leads to problem of choice.

There are three methods of stating Economic relationships between economic variables like output, inputs, cost, prices etc.: Tables/equations /graphs- Tables are
sufficient only when the relationship is simple. (Price and demand) Use of Equations is necessary if the relationship is complex. Graphs are generally used when there are only two variables used.

VariablesDependant -Left side of the equation Independent - Right side of the equation
The value of the Dependant value depends on the size of the variable or variables to the right of the equal sign. D = f (P)

Price of goods x (Px) Rs. 8 7 6 5 4 3 2 Demand for commodity x (Dx ) 50 55 60 70 80 90 100

A marginal relation is the change in the dependant variable caused by a 1-unit change in an independent Variable

Economic Systems- Market mechanism with

government regulation due to presence of Externalities

Capitalism is a system of production of goods

and services for market exchange in order to make profit. The basic elements of Capitalism are private ownership; regulation via selfregulating markets; commoditization and competition; distribution of welfare through the market determination and enterprise management for profit and accumulation.

Socialism is based on State ownership of

industry and investment projects and the level of investment carried out in the economy are centrally planned. But socialism as a system of ideas and as a political movement has taken a variety of forms. Socialist traditions revolve around equality and freedom from operations.

Mixed Economy varying degrees of private

ownership of resources coexist with large and at times growing public sector.

Economic and Non economic Activities WHAT ARE ECONOMIC ACTIVITIES

Production of wealth. Distribution of wealth, Material welfare. Consumption of wealth, purchasing power income. The functional significance of Economic activities is evaluated in terms of the institutionalized value system of the total society.

WHAT ARE NON ECONOMIC ACTIVITIESEconomics deals with individuals living in a society. The Non-economic aspects of social

like cultural, political, have traditionally been beyond economic boundary.

RELATIONSHIP BETWEEN ECONOMIC AND NON-ECONOMIC ACTIVITIES The relation between economic and noneconomic is not uniform in all cases. The production of wealth under different market conditions differs under different societies. Different markets connects economy with different sec

Organization of the Economy - The Circular Flow Importance of Economics in ME But what do ME deal with?

Decisions making in Business. It seeks to examine, investigate and explore behavior of consumers and producers pertaining to a business situation. Example Chandigarh declared smoke free city

Where does Economics come in?

. Provides the logical frame work for the decision making. . Models/ Tools for micro- macro analysis. . By characterizing human behavior with a scientific blending of economic theory and business experience in Practice. Rational. Consumers and Producers watch their self interest Maximization of satisfaction and Profits respectively. . Marginal Economics use scientific approach in empirically testing business oriented economic models. Economic theory seeks to predicts and explain economic behavior. . Demand Forecasting and Forward Planning

. Theory of the Firm. Objectives of the Firm. Business and Economic Profits. Explicit and Implicit Costs . Relationship to decision Sciences. Tools of Mathematical Economics and Econometrics to construct and estimate decision models aimed at determining the optimal behavior of the firm.

Chapter One Nature and scope of Managerial Economics and relation with other disciplines.

The objective of this chapter is to introduce the framework of ME

1. Meaning and Definitions of ME 2. Nature of ME -. Micro and Macro, Science or an art, Positive or Normative 3. Features of ME 4. Scope of ME 5. ME is interdisciplinary 6. Importance of ME 7. Role of Managerial Economist in Business 8. Responsibility of Managerial Economist

Meaning of ME
Managerial Economics is about the criteria for rational decision making by managers of business enterprises. The criteria can be applied

to non commercial decision making also like government, home. The fundamental principles on which the criteria is to be based is economic in nature. Managerial Economics uses economic concepts and quantitative methods to solve Management problems. So, Managerial Economics is the application of economic theory to business Management. Decision-making is the process of selecting a particular course of action from among a number of alternatives Managerial Economics is also called Business Economics, Economics of Enterprise, Applied Economics and Managerial Analysis. Managerial Economics lie on the Interface between Economics and Business management and serves as a bridge between two disciplines. It takes the concept Business, Accounting, Money-cost, Revenue, Profits etc. and modified these to make these fit for use in Decisionmaking.

The accountant has only with historical data with him while the managerial economics needs forecast of demand like Cost, Prices, Market share and profits. Therefore ME draw his data from Accountant and Engineers and use it to advice the management of the firm. So ME draws its tools and Techniques from three disciplinesEconomics, Accounting and Management Techniques.

Definitions of ME
Two divergent views Brigham and Pappas, the application of economic theory and methodology to business administration practice Hague a fundamental academic subject which seeks to understand and to analyze the problems of business decision making

Common features of different viewpoints

1. Concern with decision making of economic nature. Identification of economic choices and allocation of scarce resources. 2. Managerial Economics is goal orientedprescriptive. Decision in achieving goals. 3. Concerned with analytical tools, which are useful and improving in decision making. 4. Provides necessary conceptual tools to decision making of a particular problem. 5. Link between traditional economics and decision sciences. Integration of economics theory and Business practice. Economics theory is based of assumption (PC), which may not be valid in reality. A managerial economics rule is too modified and extends the theoretical construct of economics to conform to the actual business behavioral. Firms operate under various degrees of uncertainty about market conditions therefore

the actual behavioral of firms deviates from profit maximization. Managerial Economics attempt to estimate and predict economic quantities and relationships. The Tools used are Elasticity of Demand, demand forecasting, MC are needed for decision making and Forward Planning. (Micro Economics) and Environment within which firms have to operate (Macro Economics) are useful.

Features/Characteristics of ME
1. Micro economics Units of study individual firm does not deal with economy 2. Help of macroeconomics Firms have to adjust in environment in which it has to operate 3. Particular environment of decision-making 4. Normative Prescriptive rather than Descriptive involves value judgment is the increase in price as a result of which demand decreases. It has to decide whether it is good or bad of the firm

5. Conceptual to understand and analyze decision problem and uses. Quantitative to measure the impact of different factors and policies 6. Theory of firm 7. Wise choices Goal oriented and maximum achievements of objectives 8. Multi-disciplinary

Importance of ME
1. Evaluating choice alternatives 2. Making the best decisions 3. Managerial ethics 4. Tools and techniques 5. Knowledge of concepts 6. Idea from other subjects 7. Social benefits generates Y, N 8. Promotion of sales 9. Decision-making 10. Helpful to New Age Managers- Intellectual Property Rights 11. MNCs

The role of ME in business Decisionmaking

But what are the Management Decision making problems? . Product selection, output, and pricing . Internet strategy . Organization design . Product development and promotion strategy . Worker hiring and training . Investment and financing

Economic Concepts

Quantitative methods /Analytical tools

. Marginal analysis .Numerical analysis . Theory of consumer .Statistical estimation Demand . Theory of the firm. .Forecasting Procedure . Industrial organization. .Game theory concept And firm behavior . Public choice theory .Optimization Techniques . Information system

Managerial Economics Use of economic concepts and Quantitative Methods to solved management decision Problems Optimal solutions to managerial Decision problem (Under given circumstances)

The flowchart of the decision-making process within a firm Product demand Estimate Output Decisions


Input Supply Information

Input decision

Production Process Decision

Production Technology Information

ME is interdisciplinary 1. Managerial Economics and traditional Economics: Economics provide certain basic
concepts and analytical tools which are applied suitably to a business situation. Economics and Managerial Economics deal with identical problem. Problem of scarcity and resource allocation (Alternative uses) Economics concentrate on the study of types of markets. Managerial Economics is concerned with problem like the impacts of markets or technological changes on competitive position of the firm and the likely reaction of their own actions in the market.

The two main contributions of the economics to Managerial Economics1. Help in understanding the market condition and the general economic environment within which the firm operates. 2. To provide a philosophy for understanding and analyzing resource-allocation problems

There are two types of efficiencies in business operations with which ME is concerns Economic efficiency (Profits) necessary for
survival of a firm (Maximum output at minimum cost)

Technical efficiency (Product function)

but business can survive and grow in spite of technical in efficiency.

Operations Research and ME:

Both are concerned with taking effective decisions Both are concerned with best way of achieving firms goals. Managerial Economics is a fundamental academic subject to analyze the problem of business decision making. OR is an activity carried out by functional specialists within the firm to help the manager to do his job of solving decision problems and is also concerned with model building. It is more job-oriented and situational (Linear Programming)

1. Expensive so should be used only for complex problems and where the potential savings from the OR is large enough to make its use profitable.

2.Should be used when the solution to one firms problem can be applied to a whole range of similar small problems over a period of time, so that substantial savings can be obtained by applying the results time of time which will make the initial expenditure on OR worth while. 3. Slow- It reaches accurate rather than rapid solutions but Manager must get quick and cheap result. Managerial Economics provides the manager the tools with which he can carry out instant OR and reach same kind of solutions as provided by OR.

ME and Mathematics:
Math provides a set of tools, which help in the derivation, and exposition of Economic analysis. Managerial Economics is conceptual as well as metrical. Estimate and predict the relevant Economic factors for decision making and forward planning.

Math is preferred to a descriptive analysis (ME). It has wider scope. Symbols are more convenient to handle and comprehend. Math used in ME, Geometry, Algebra, Calculus, Input-output tables

ME and Statistics:
Managerial Economics aims at quantifying the past-Economic activity as well as to predict a future course If the firm wants to decide about pricing of its product, its must have the knowledge of its existing demand and production situation and also of the likely changes in it. So, that, an appropriate pricing policy can be decided.

Managerial Economics and Uncertainty

Decision making based on the theory of Probability. ME and the theory of Decision-making (Recent introduction)

In ME economics aims at a single goal like maximization of utility / profits based on the assumptions like perfect knowledge. Decision-making aims at multiplicity of goals and uncertainty in real world. Often the notion of single optimum solutions is replaced with the view of finding solutions that balance conflicting objectives. Motivation and reward, pattern of influent and authority. Economic theory and decision-making based on a different set of assumptions. Economic theory is easy to apply in slow moving situations with clear-cut objectives. It is less capable of handling complex problems with multiple goals where Decision-making is more relevant. Managerial Economics offers opportunity to integrate ideas from the various specialized functions and disciplines into and overall point of view-The perspective of a good manager.

Role of a Managerial Economics: Primary

1. Decision making 2. Forward planning 3. Specialized in the basic economic theory (Knowledge-statistical tools) to solve the problems of business management 4. Organizing and processing information

Specific functions:
1. Producing scheduling 2. Demand forecasting 3. Market research 4. Economic analysis of the industry 5. Investment appraisal 6. Security management analysis 7. Advise of foreign exchange management 8. Advise on trade 9. Pricing and related decisions 10. Analyzing and forecasting environmental factors.

Decision-making is affected by two types of factors: Decision making factors

External Internal: (within the firm) (Environment) (Flow chart of decision-making) Macro Micro 1.General economic condition 1.pricinf and profit policies 2.Demand for the product-purchasing power 2.Investment decision 3.Input costs credit policies, economic economic information

-Policies. Prices of rival products, tax rates Consumers attitude 4.Market conditions. Raw materials 4.Fast changing technological , Finished products, subtitude development 5.Expention of the firm share in 5.Mangerial planning The market Responsibility of a managerial economist 1.Better management of physical and Human resources 2.Decision-making and forward planning. 3.Economic forecast 4.Goal of maximum profit. 5.R&D

6.Additional information, personal contacts, joins professional association Essential qualifications of a manager: 1.Diplomacy 2.Through knowledge 3.Behavior-conceptual 4.Creativity 5.Initiative 6.Intutive ability Scope/Nature of Managerial Economics: 1.Is Economic a science or an art? 2.Is Economis a positive science or normative science?

3.Distinction between micro and macroeconomics Is Economic a Science or an Art? First we must define a Science- Science is a systematic and comprehensive study of knowledge which explains the cause and effect relationship. Feature of Science: 1.Systamatised of a subject 2.Establishesis relationship between cause and of a effect 3.Laws of Science are universal. Arguments in favor of Economic as a Science: Prof. Robbins, Robertson 1.Economics- Systamatised stydy. Collection ,classification and analysis of economic facts. Subject matter of economics is systematically divided into

consumptions,production,exchange and distribution. 2.Laws of economics similar to Laws of other Sciences. Established caused and effect relationship of economic activities (Law of Demand) 3.Exprements- Capitalism, Socialism and mix economy are the experiments of the economics. 4.Measuring Rod of money as made economics a more certain science then other social sciences. Economic has the quality of quantitative measurement of a science. 5.Universal- Laws valid in all types of economics (Law of Demand). Argument against economic as a science (As a pure science like Physics and Chemistry)

1.The laws of economic are not universal. They are based on assumption which are not valid over time and space. Therefore economics is less than a pure science. 2.The laws of economics are not so exact. Ceteris paribus Other things remaining same. 3.No possibility of laboratory experiment. The object of economics is Man who is subjective, uncontrollable real world. 4.Conflicting views. Lack of unanimity among economics. Sign of lack of maturity in economics as a science. 5.Difficulties in making predictions. So can not be considered as a pure science . At best it is a social science.Economic man is a social man. Economics is an Art: prof. Pigou Art is the practical application of knowledge for achieving definite ends.

J.M.Kenynes An Art is a system of rules for the attainment of a given end. Art is the action with purpose. Art directs, Art imposes precepts, or proposes rules, Its solve general problems. A science teacher us to know, and Art teacher us to do. Example Science- The fact that there is unemployment in India (Positive) The aim of the is to achieve full Employment (Normative Science) Art- Government takes monitory and fiscal steps to remove Unemployment. Arguments in favor of economics as an art: 1.Solutions of problems- Practical application of knowledge. It solves the fundamental economic problem of relative scarcity and the problem of choice

2.It tries to promote the human welfare. 3.Varification of economics laws (Law of Demand) Conclusion: Science requires art; Art requires science, each being complementary to each other. II. Is economics a Positive or Normative Science? Positive Science- Only explores what is the facts and is neutral between ends Economics as a positive Science explains the relationships between cause and effect (Law of Demand). So its explains what is, How is works and what are its effects. Example- what is wage rate, how it is determined and why wage rate in India is low?

Robbins, Senior and Friedman- Economics could not add even one word of advice. Robbins The function of an Economist is to explore and explain and not to advocate or condemn. Economics is neutral as regard ends. The function of the economics is not to give value judgments. Regarding the merits and de merits of facts and laws. Arguments given in favor of Positive Science: 1.It is based on logic. Cause and effect relationships (Law of Demand) 2.The function of an economics is to explain the facts about the economics activity only. He should be silent about what is good or what is not good. This job should be done in ethics.

3.Fear of confusion- If economics deals with the two question simultaneously. What is and what ought to be they will be confusion (What is the wage rate and also what is should be). 4.More uniformity The study of what ought to be will cause much controversy in the subject. Different economists will give different opinions. Economics as a positive science will grow. 5.More neutrality: If economics deals with what is and what ought to be than economist cannot remain neutral. Economics as a Normative Science: Pigou, Marshall; what should be idle as distinguished from the actual. Gives decisions regarding value judgments. Economics Ethics the real function of all sciences is the use we can make of it to promote the ends of human welfare.

Economics cannot be neutral as regards ends. Arguments in favor of Economics as a normative science: 1.Man is not only logical but also sentimental. Man is not always Rational. Economics is positive as well as Normative. 2.Not only cause and effects but also provides remedies. 3.Equilibrium: Price is determined by D and S forces, but does not mean that it is the optimum price level for the society and Government should not take any measures to control the price rise. Economics cannot be neutral as regards ends. 4.A means of social betterment promote human welfare So Economic cannot be separated from ethics. All economics suggest policies /solutions.

Keynes- Unemployment Malthus- Population 5.Basis of economic planning. Duty of economic is to prescribe economic policy. Economics is both a positive and a Normative Science (Prescriptive and Descriptive) III. Distinction between Micro and Macro Economics: SQ 1. Distinction between Micro and Macro Economics: 2.What is Macro Economics? 3.Utility of Macro Economics. Meaning of Micro Economics: (Small) concerned with the behavioral of individual. Specific/particular economic units/variables/particular firms/How sold individual prices/wages/income etc.

Individual decision-making and the problem of resource allocation. What/when/how/at what price. How/what to distribute Approach is specific and non-aggregate. (Classical Theory) Meaning of Macro Economics :(Large) functioning of the economy as a whole (N.Y Employment Economic growth) Features of Macro Economics: 1.Short run in nature as aggregate is assumed to be constant. 2.Study of the whole economy. 3.Systamised and comprehensive body of thought (All types of Unemployment). Importance/Uses of Micro economics:

1.Explains price determination and allocation of scares resources. 2.Relevance in business decision-making. 3.Price determination. 4.Consumer satisfaction. 5.Estimation of cost of production. 6. Demand forecasting 7.Guide to policy formulation- Taxes. 8.Basis of welfare economics- Paretio Optimality. When you can not make anyone better off without making someone worse off 9.International trade, determination of exchange rate Limitations of Micro Economics: 1.Marginal concept-. Considered only single unit change. Whereas firms make bulk changes (MU, MC, MR, MP) Practical difficulty. 2.Individual Equilibrium (MU=Price)

3.Unrealistic assumption of full employment even in a short run. 4. Pure capitalist model. 5.Misleadind generalization explains only a part of the whole using deductive method It assumes welfare of the individual will live to society welfare. The summation is that what is true for the individual and is also true for the Economy as a whole. Which is not true (Private saving is a virtue but public vice- Keynes) Thus, Social welfare assumed away. Limitations of Macro Economics: 1.Dependence on individuals (Aggregation) 2.Heterogeneous units cannot be aggregated. Money used as a Statically unit. 3.The composition of structure of the aggregate is more important than the

aggregate itself. Not N.Y. but its distribution is more important. 4.Different effects of aggregates-Wages double-edged weapon. 5.Limited applications. Only theoretical significant. 6.Ignores the contribution of individual units. Importance of Macro Economics: 1.Keynes 1936. General theory. Revive the Economy out of depression. 2.Helpful in understanding functioning of the economy. 3.Study of N.Y. 4.Formulation of Economical policy. 5.Study of trade cycles. 6.Change in general price levels. 7.Economic growth.

8.Helful in the study of Micro Economics (Law of Demand, Law of MU, Group behaviour of consumers). 9.Interrelationships among different sectors. 10.Helpful in understanding MacroEconomic parameter. 11.Estimate material welfare- Standard of living. 12.International comparison. Micro Macro 1.Difference in the degree Single Economic unit-firm,industry Aggregate of Economic variables of aggregation Economy 2.Differences in objectives Study of principles,problems and Full employment and growth.

policies relating to the optimum allocation of resources. 3.Price and Income importance Price theory Income theory Economic units- consumers, producers Economics deciosion regarding FOP take their decisions on the basis of aggregate C,aggregate S, Price. Aggregate I. Calculated on the Basis of income 4.Differnces in the method equilibrium Analysis Quasi general equilibarium Partial

of Study paribus analysis. remaining constant Change in one economic factor effects other aggregates.agg D agg S ,agg C. Y=C+S.

ceteris Other things

5. Paradoxes Private saving virtue for Economies private saving vice .individual

.Money wage reduction- decreases cop Money wage reduction-increases N. Decreases Y,Decreases C, Decreases ED,decreases N. 6.Different assumptions always full N. Capitalism. Free market All levels of N. In general Economy. Under employment equilibrium 7.Analytical differences Study the behavior of Economic variables Behavior of Economic in Equilibrium position. Aggregates in this equilibrium Position.

Conclusion: ME uses both Micro and Macro. Business decision requires Micro. Consumers, producers, Owners of FOP Under given condition (Assumption.). Descriptive science But firms have to operate in an Environment Macro Economy. Subject matter of ME: Micro Economics 1.Theory of demand: Spencer and Siegelman , A business firm is an Economic organization which transforms productive resources into goods that are to be solved in the market Demand analysis- Factors that influence the demand of product of a firm.Essential for forecasting for business planning.

Demand theory- Study of behavior of consumers. 2. Theory of productions: Output analysis. Pf, costs, volume. Determine the level of production at which AC may be minimum. How can optimum size of production be obtain. 3.Theory of Exchange Or price theory: How commodity prices are determined under different types of market conditions. Price policy of the firm. Pricing methods, pricing polices, differential pricing, price forecasting. 4.Theory of Profit: TR-TC. Uncertain. Profit planning and profit management are necessary for improving profit-earning efficiency of the firm. Risk has to be minimized as far as possible. Expected and unexpected risk.

5. Theory of Capital and Investment (Scares and expensive): (a) Selection of most suitable investments project (b) Most efficient allocation of capital (c) Assessing the efficiency of capital (d) Minimizing the possibility of under Capitalization Or Over capitalization. Macro Economics: 6.Enviornmental issues: Social and political environment in which a business and industrial firm has to operate (a) The type of the economic system of the country. (b) Business cycles (c) Industrial policy of the country. (d) Trade and fiscal policy of the country. (e) General trend in the economy with regard to production, N, Y, P, S and Investment, Foreign trade.

(f) Social factors like the value system of the society. (g) General attitude and significance of social organizations like trade unions, producers unions, and consumer cooperative societies. (h) Social structure and class character of various social groups (i) Political system of the country. Management of the firm has no control over these factors. It has to adjust the plans, policies and programs according to these factors

Basic concept in Decision-making

Opportunity cost, Marginal analysis, Incremental analysis, Time perspective, Discounting SQ1. What do you understand by Incremental concepts? 2.What is Discounting? LQ1. What is Marginal analysis? How is it different from Incremental analysis? Describe Incremental analysis in detail. Incremental reasoning: Involves estimating the impact of Decision alternatives. There are two basic concepts in incremental analysis: Incremental cost: Changes in total cost as a result in change in the level of output, investment etc.

Incremental revenue: is the change in the total reve nue. Resulting from a change in the level of output, price etc. Criteria of Business-decisions- manager always determines the worthwhile ness of a decision on the basis that IR>IC Example- A firm gets an order which can get it and additional revenue of rupees 200. The normal cost of production of this order is A B Labor 400 Materials 800 Overheads 200 600 800 720

Selling and administration -


Expensive Full cost 2400 1400 A B IR<IC Net profit IR>IC 2000<2400 2000-1400=600 Lose rupees 400 by accepting the order order is acceptable Order is unprofitable But the order would be using existing facilities and under utilize capacity, only a marginal addition is required on overheads. Some labor, which was partially idle, is better utilize and there is no addition to selling and administration expenses.

The concept of Incremental reasoning is of extreme significant. It is possible that the additional unit may be addin less to cost than revenue, and by rejecting the possibility of additional unit of production. The manager(firm) lose additional profit. According to incremental rule, this behavior is inconsistent with the goal of profit maximization. The concept of incremental reasoning is quit helpful in optimal allocation of resources. Theorem1- A course of action should be pursuit uptown the point where the incremental benefit =Incremental cost. The worthwhile ness of a decision can be judged on the basis of two main theorem of Marginal equivalency or Incremental Reasoning:

Marginal Analysis A variant of Incremental reasoning is the concept of marginal equivalency which takes into accounts. The changes in the dependent variable due to a unit change in the independent variable (Change in cost due to audit change in output). TheoremII. Different courses of action should be pursuit Up to the point where all the courses provide equal marginal benefit per unit of cost. Both theorems can be explained with the help of table Profit function of a Firm (At different levels of output) Rs.(price rupees 20 per unit)

Units of output Total revenue Total cost Total profit Marginal profit 1 2 3 4 5 (2-3) 1 15 2 29 3 42 4 52 5 65 6 81 20 20 5 40 11 60 18 80 28 100 35 120 20 39 6 7 10 7 4

7 101mc 8 125

140 mr 39 160 35

zero (-) 4

Marginal profit at any output level is the total profit at that output level(-) in the total at the preceding output level . [Marginal profit of the nth unit= Total profit of n units-total profit of (n-1units)] According to theorem1 the firm will produce only 7 units of outputs, where MR=MC at that level of output. The MC of the 8th unit is more than its MR. MC>MR (24>20) The firm gets negative profit (loss) from the 8th unit. Consequently the firm will not go beyond 7 unit of output. On the other hand, If stock before the 7th unit(say 4th unit) then it is

loosing the profits which the subsequent units(5th, 6th, 7th ) could have contributed. But if the firm has some idle capacity in terms of machinery, equipment and labor, the execution of a new order may not raise the cost must. So the output, which otherwise would have been unprofitable may be profitable in the idle capacity case. Theorem 2(equi-marginal principle): States that an input must be so allocated between various uses that the value added by the last unit of the output is the same in all its uses. Various alternatives uses of a given factor therefore the problem of allocation resources in various alternatives. Therefore, it is important to know the marginal increase In output from the alternative uses of that input.

If the firm is producing more than one output, it would use its input in the best way, if the last unit of the input produces equal output in each case. If the marginal contribution of the input between different outputs are unequal, the firm would continue reallocating the input from low-contribution use to a Highcontribution use until its marginal contribution to all outputs become equal. Suppose a businessman is pursuing two outputs, A and B Expenditure (cost) of rupees hundred. Yields marginal profit of Rs.150 and Rs.175 It would be worth his while to transfer rupees hundred of cost from A to B. Lose rupees 150 from A. Gain of rupees 175 from B.

Net gain of rupees 25 with no extra cost. But as he shifts his expenditure from A to B , the marginal profit in A goes up and the marginal profit in B goes down due to change in prices. Price in B and price in A Thus reducing the Gap between the marginal profits of the outputs. It would pay him to continue reallocating his expenditure in this way (Thus decreasing the gap between the marginal profit each time) Until both A and B provide the same marginal profit per rupees 100 of expenditure. Thus Equi marginal principle is very important for decision-making. When there are more than one input to be used and the prices of these inputs are different, then the ratios of marginal productivity may be equated to the ratio of their prices. MPx = price of x

Mpy Or

price y

MPx = Mpy Px Py Productivity per rupee spent on the input Generalize this optimal allocation for more than two inputs MPx = Mpy .. MPn Px Py Pn = MPz Pz

Comparison of Incremental reasoning and Marginal analysis: Marginal Analysis Incremental Reasoning in unit change in independent 1 Express in bulk change. It could be associated with Variable change in cost as a result of a a change in any number of unit, moreover it may Unit change in output. Not have any relationship with quantity. There can can be an incremental cost of quality improvement useful to use in linear function. 2.More appropriate to use whenever cost and 2.Multivariable function. More than one independent Revenue functions are curvilinear, because variable may be using incremental analysis and it is

Marginal analysis cause for a unit-to-unit not possible to capture the range of output that lies Comparison and would, therefore, be able to between the initial point and the point of change. Capture the impact of all points. 3.Tedious job of comparing unit-by-unit impact 3.Only the end point of a range are to be compared, as needed in marginal analysis. And marginal analysis would also not give any Different result than incremental reasoning. 4.It cannot be used in case of discrete alternative. 4. Can be used in discrete cases. More general. Morespecific.Where precision is required

5.MA is a special case of reasoning. All 5. All incremental concepts need not be marginal Marginal concepts are incremental. Concepts 6.Neither necessary nor practical in real life 6. Use more frequently in business decision. Business consideration. 7. In cost minimization it can be used only 7. Can be applied both for fix and variable cost For variable cost (which changes over time) changes. But not in case of fix cost 8.Producing and selling large products and 8. Most business firms produce and sells bulk Goods like airplanes, ships. Conclusion:

Incremental reasoning and marginal reasoning are closely related. There are similarity and differences. In certain decision problems incremental reasoning is more efficient, while in some other cases marginal analysis are more suitable. Opportunity Cost: Problem of Choice. Resources relatively scarce can be put to alternative uses. Unlimited ends. Logic- With limited resources, a decision to have more of one thing is simultaneously a decision to have less of something else. Hence Opportunity Cost any decision is the value of the next best alternative that is given up. Rational decision-making must be based on O.C. calculation. Example: Decision to produce more cars, therefore to produce fewer refrigerators

Cost per car is rupees 50,000 but it real cost to society is the refrigerators that the society must for go to get an additional car. If labor, steel and energy (Limited resources with the firm) needed to manufacture a car are sufficient to make 30 refrigerators. Then OC of a car = 30 Refrigerators Limited resource force hard choices on business managers and society as a whole. Guns or Butter House hold: How to divide its income among good and services that compete for families attention. Car/T.V./New computer/digital camera/mobile. The OC of a decision is the cost of sacrificing the second best alternative to that decision. In order to compare the alternatives it is necessary that the costs of sacrifices involved are measured (If there is no sacrifice, then no OC is involved).

OC are not recorded in the accounting record of firm, but they have to be met if the firm aims at optimization. Examples: 1, The OC of the fund employed in ones on business is the amount of interest which could have been earned had these funds been invested in the next best channel of investment. 2. When a product X rather than product Y is produce by using a machine, which can produce both, the OC of producing X is the amount of Y sacrifice as a result. 3. The OC of using an ideal machine is zero, as its use needs no sacrifice of opportunities. 4. The OC of ones labor in ones own business is the income one could have earned by accepting a job outside. OC requires that sacrifices must be clearly ascertained these sacrifices may be monitory or real. Monitory cost can be expressed as

explicit (Express in accounts like payment to labor) While Real cost are implicit. Imputed. Sacrifices that are not recorded in accounts (Cost of capital supplied by Owners of business). OC includes both Implicit and Explicit cost, the OC of an alternative therefore, is generally higher than it a accounting cost (Explicit cost). Comparison Incremental Cost Opportunity Cost 1. Difference in accost due to a decision 1. All economic cost included of a scares input

IR-IC= gain. From a purpose change in the TR-OC= gain from the purposed use of scares Activity input (Of the chosen alternative). 2. Shows the contrast between the sunk costs 2. Net revenue that could be generated in the next (The cost that does not be change with the change best alternative use of scares resources. In activity) and the cost that change with a change in the level of business activity. Time perspective: Economist distinguishes between Short-run and Long-run Short-run: Fix inputs cannot be alter. Variable+fix factors. Changes in output can be achieved by changing the intensity of use of fix inputs.

Long-run: All inputs can be change. Change in output can be achieved by adjusting scale of output (Size of firm). Also new firm can enter and the existing firms can leave. ME economist do not adhere to the strict theoretical time distinction of an economist. They do not see the time distinction in terms of whether all the inputs are variable or not. To a managerial economics, short period is the immediate future and long period is remote future. Principle of time perspective for a managerial economist: A decision should take into accounts. Both the short-run and long run effect on revenues and costs so as to maintain right balance between long run and short-run perspective.

A manager must make relevant distinction between the present and future implication of his policy. Haynes, Mote and Paul mention the case of a printing company, which wanted to avoid the image of an exploiter. It pursued the policy of never quoting prices below the full cost, even if there was some idle capacity. It realizes that the long-run repercussion of pricing below full cost would more than offset any short-run gain. Moreover, it did not want to project and impression that the firm wanted to exploit the market when the demand was favorable but was willing to reduce prices when the adequate demand was not forthcoming. Example: Firm has temporary idle capacity An order of 5000 units comes to management attention.

Customer is wiling to pay rupees 4 per unit or rupees 20,000 for whole lot but no more. [Ignoring fix cost] The Short-run incremental cost is only rupees 3 per unit (Total cost rupees 15,000). Therefore overhead profit = rupee 1 per unit (Rupees 5,000 for the whole). Analysis: 1.If the management commit itself with too much of business at lower prices or with a small contribution , it may not have sufficient capacity to take a business with higher contributions when the opportunity arises there after. 2. If other customers come to know about this low price they may demand a similar low price. (Ethical views on pricing). Then the reduction of pricing under condition of excess capacity may adversary

effect the image of the company, ultimately affecting the sales. Discounting Principle: In a way this is an extension of the concept of TP. Since future is unknown and in calculable, there is a lot of risk and uncertainty about future. Moreover the return in future less attractive in then the same return today. The future must, therefore be discounted both for the elements of delay and risk of future. 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. Even if one is certain about future income, yet it must be discounted because to wait for future implies a sacrifice for the present. Example: Given a choice of rupees 1,000 today or rupees 1,000 next year. Rational choice will be rupees 1,000 today.

Suppose 10% interest is given during the year then the choice is between rupees 1,000 today or rupees 1,100 next years. Indifferent or prefer either? It means rupees 1,100 after an year has a present worth of rupees 1,000. Therefore, making a decision regarding investment, which will yield return over a period of time, it is advisable to find its net present worth. Unless these returns are discounting to find their present worth, it is not possible to judge whether or not it is worth undertaking the investment today. The net worth may be calculated for various investment proposals. Some of which may yield higher returns in the earlier while others higher returns in later years. Some investment may yield returns for only a limited number of years while a small return for a long of period.

Some investment may yield higher returns for only a limited numbers of years, while the others a small return for a longer period. Thus, even the same amount of investment in two alternatives uses may have different amount returns and a different duration of such returns. To transform these returns into a common measure we use the discounting principle. Example: Suppose an investor wants to invest rupees 100. Assuming the bank rate of interest is 10%. The choice is between physical investment and financial investment had he not invested (Physical investment) he would have earned at least this rate of interest and his money would have grown rupees 100 to rupees 110 to nest year.

So, he would make investment in a firm only when his investment becomes worth at least rupees 110 next year. In other words rupees 110 next years have a present worth of rupees 100. Rs 110 next year = Rs 100 today In case of present worth, we bring all of the future rupees up to todays rupees. Another way in which we can put it: (Rupees 100 is what you want to earn after one year) Then at 10% rate of interest how much should be invest today so that it produces a return(R) of rupees 100 at the end of one year. The present value or the discounted value of rupees 100 will then be V1 = R Rs.90.90 1+I = 100 1.10 =

So if you invest rupees 90.90 today, it will grow to rupee 100 after one year. We can thus right the present worth of a stream of incomes spread over n years. R1 R2 R3 Rn (1+I) , (1+I)2 , (1+I)3 (1+I)n Concept of Contribution: This concepts take help from both the principles of Incremental reasoning and OC. It gives the contribution of a unit of output to overheads and helps in determining the best product mix when allocation of scales resources is involved.It also indicates whether or not it is advantages to except a fresh order, to introduce a new product, to shut down, to continue with the existing plant, etc.

Unit contribution = Incremental Revenue Incremental Cost per unit. In case of a firm with excess capacity, a new product can be introduced easily as it is likely to contribute very little to cost but significantly to revenue. And, some contribution is better than none. On the other hand, if the firm has back log of orders for existing products then the new product, it introduce, will have to compete for the use of the same production facilities which the existing product are using. In such case the choice between clearing the back log order of the existing product and the introduction of new product will depend upon their respective contributions. Production facilities will be allocated on the basis of, which of these products can contribute more. Thos suggest that the product should be compared on the basis of their contributions per unit of scares resources

used. The optimum product mix can, thus, be determined. The term contributions to overhead and profit widely used in pricing product-mix decisions, replacement analysis and capital budgeting