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CHAPTER 1

DEFINITION OF ECONOMICS:

PRELUDE:

Economics is a social science; a classified body of knowledge concerning human relationships clustered about
man’s effort to earn a living.conomics is quite an old discipline. That is why Prof.Samuelson remarks that
Economics is the “Oldest of the arts, newest of the sciences, indeed the Queen of the social sciences”.

The origin of the subject could be traced to the works of the Greek philosopher, Aristotle who confines the study
of economics to household management and acquiring and making proper use of wealth. It is important to note
that the word ‘Economics’ has been derived from the Greek words ‘Oikos’ (a house) and ‘nemine’ (to manage).
Thus economics means managing a household with limited funds. Adam Smith’s magnum opus book “ An
enquiry into the nature and causes of wealth of Nations” published in the year 1776, laid a strong foundation for
the growth of economics. So Adam Smith is rightly called as the “Father of Economics”. Although there is a
plethora of definitions, there is no concord among economists about a precise definition.

1. DEFINITION OF ECONOMICS:
The Various definitions can be classified broadly into three categories:

1. A science of wealth

2. A science of material welfare and

3. A science of scarcity

1.1 A SCIENCE OF WEALTH:


Adam smith, J.B.say, F.A. Walker and other economists of the 18th and 19th centuries have defined economics as
that part of knowledge which relates to wealth. Adam smith considered that the main aim of all economic
activities is to amass as much wealth as possible. It is, therefore, necessary to analyse how wealth is produced
and consumed. Most classical economists supported the Smithian definition of economics.
Wealth definition gave rise to serious misconceptions at the hands of some literary writers of the 19th century
like Ruskin, Thomas Carlye, Charles Dickens,William Morris and Mathew Arnold. Economics was branded as
the ‘ bread and butter science’ , ‘The Gospel of Mammon’ , “ a science that taught ‘ selfishness and love for
money’ , ‘ a dark and dismal science’ , a bastard science, a pig science” and so on.

1.2 A SCIENCE OF MATERIAL WELFARE:


Adam Smith’s wealth definition made economics a dismal science. Alfred Marshall was the first neo-classical
economist to rescue economics from ridicule, condemnation and misunderstanding. Marshall reoriented
economics and placed it on the pedestal of glory, in his classic work ‘ principles of Economics’ published in
1890.

Marshall in his definition, shifted the emphasis from wealth to human welfare. According to him. Wealth is
simply a means to an end in all activities, the end being human welfare.

In Marshall’s own words, “political Economy or Economics, is a study of mankind in the ordinary business of
life; it examines that part of individual and social action which is most closely connected with the attainment and
with the use of the material requisites of well being”. He adds that economics “is on the one side a study of
wealth; and the other the more important side, a part of the study of man”.

Lionel Robbins led a frontal attack on the welfare definition in his immortal work, “An essay on the Nature and
significance of economic science” published in 1932.In the words of Robbins, “The material list definition of
economics misrepresents the science as we know it”.

1.3 A SCIENCE OF SCARCITY:


After rejecting the materialist definition of Marshall, Robbins formulated his own conception of economics .In
the words of Robbins, “Economics is the science which studies human behavior as a relationship between ends
and scarce means which have alternative uses”. This definition is based on four fundamentals characteristics of
human existence.
1.3.1 HUMAN WANTS ARE UNLIMITED

“Ends” refer to human wants which are unlimited but the resources available to satisfy them are unlimited.

1.3.2SCARCITY OF MEANS

The resources(time or money or both) at the disposal of a person to satisfy his wants are limited. If things are
available in abundance just like free goods, the economic problem will not arise. But as Prof.Meyers says,
“Alladins lamps” exist only in Arabian fairy tales.

1.3.3ALTERNATIVE USES

Economic resources are scarce, but they can be put to alternayive uses. If we choose one thing, we must give up
others.

1.3.4THE ECONOMIC PROBLEM

When the means at the disposal of a person are limited and the resources can be put to several uses, and when
wants can be graded on the basis of intensity, human behavior necessarily takes the form of choice.

Recently, Prof.Samuelson has given a definition based on Growth aspects which is known as the “Growth
Definition”.

MANAGERIAL ECONOMICS

MEANING

Managerial economics lies on the borderline of management and economics.It is a hybrid of the two disciplines
and is primarilyan applied branch of knowledge.The development of the science of managerial economics is of
recent origin. After the Second World War and particularly after 1950, with rapid expansion of international
trade, the Business Managers faced numerous delicate problems. As Professor Ansoff says, “since the early
1950s confronted with the growing variability and unpredictability of the business environment, business
managers have become increasingly concerned with rational and foresightful ways of adjusting to an exploiting
environmental change.”

There was a gap between economic theory and the correct procedure they have to employ to problems. The
problems of the business world attracted the attention of academicians and gave rise to a special treatment of
business problems. As a result managerial economics came into being.

2. DEFINITION OF MANAGERIAL ECONOMICS

Managerial economics has meant different things to different people. In simple terms managerial economic
means the application of economic theory to the problems of management.

Prof. Spencer and Siegelman defined managerial economics as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by the management.”

It is clear from this definition that the problems of management are two fold. They are (i) decision making (ii)
forward planning. Decision making is a process of selecting a particular course of action from among a number
of alternative options. Forward planning means preparing plans for the future. Forward planning and decision
making goes hand in hand.
We may define managerial economics as application of economic theory and decision science tools to problem
of managerial decision.

The following chart will make the concept clear.


3. DISTINCTION BETWEEN ECONOMICS AND MANAGERIAL ECONOMICS

Economics has both micro and macro analysis. The roots of managerial economics spring from micro
economic theory.
Economics is both positive and normative in character. Managerial economics is basically normative in
character.
Economics mainly deals with the theoretical aspects of Managerial economics is concerned with practical
the firm. problems of the firm.
Micro economics, as part of economics deals with Managerial economics deals with firms and not with
individual and firms. individuals.
Economics studies principles underlying wage, rent, Managerial economics studies mainly the principles of
interest and profit. profit only.
Economics deals only with economic aspects of the Managerial economics deals with both the economic
problem. and non-economic aspects of the problem.
The scope of economics is wide. The scope of managerial economics is narrow.

4. SCOPE OF MANAGERIAL ECONOMICS

4.1 DEMAND ANALYSIS AND FORECASTING

It analyses the various types of demand which enable the manager to arrive at a reasonable estimate of the
demand for the products of his firm. When the current demand is estimated, the next logical step is to ascertain
the future demand for his products. The main areas cover under demand analysis is demand determinants
demand distinctions and demand forecasting.

4.1.1 COST AND PRODUCTION FUNCTION

Cost and production analysis is vital for the efficient allocation of scare resources. This analysis is also useful for
profit planning, project planning, cost control and pricing of products. While cost analysis is done in monetary
terms, production analysis is done in physical units. The major areas cover under cost and production analysis
are cost concepts, and classification, cost output relationships, economies and diseconomies of scale and cost
control.

4.1.2 PRICING DECISIONS, POLICIES AND PRACTICES

Pricing is an important area in managerial economics. While fixing the price of a commodity, a complete
knowledge of the price system is essential. The success or failure of a firm mainly depends upon its accurate
price decisions. Pricing policy has considerable significance for the management only when there is a
considerable degree of imperfection in the market. The main areas covered are price determination in various
market structures, pricing methods and price forecasting.

4.1.3 PROFIT MANAGEMENT

Profit is the life blood of any organization. An element of uncertainty exists about profit due to variations in cost
and revenues. If knowledge about the future were perfect, profit analysis would be much easier. The important
areas covered are profit planning, profit management, profit forecast and profit measurement.

4.1.4 CAPITAL MANAGEMENT

Capital management means planning and control of capital expenditure. Capital measurement is done through
capital budgeting. Cost of capital, rate of return and selection of project are the important areas covered under
the capital management.

4.1.5 DECISION MAKING


It is the process of selecting a particular course of action from among a number of alternatives. In arriving at a
decision, the alternative courses of action available have to be weighted for acceptance or rejection. Operational
research have developed many techniques which are frequently used in managerial economics for this purpose.

5. NATURE OF MANAGERIAL ECONOMICS

5.1 SPECIAL BRANCH OF ECONOMICS

Managerial economics is a special branch of economics bridging the gap between theory and practice.”The
relation of managerial economics to economic theory is much like that of engineering to physics or of medicine
to biology or bacteriology”.

5.1.1. MICRO ECONOMIC IN CHARACTER

Managerial economics draws heavily on the propositions of micro economic theory. For eg., demand concepts
and theories of market structure are elements of micro economics which managerial economics uses. The other
concepts widely used are (i) elasticity of demand ,(ii) marginal cost,(iii) marginal revenue,(iv) opportunity cost
etc. But some of these concepts however provide only the necessary logical base and have to be modified in
actual practice to suit special circumstances.

5.1.2 RELATED TO MACRO ECONOMICS ALSO

Though, basically managerial economics is micro economics in nature, it uses macro economics forecasting. A
proper understanding of the functioning of the economic system is of immense importance to the managerial
economist in framing suitable policies. Concepts like business cycles, national income accounting etc are widely
used in managerial economics.

5.1.3PRAGMATIC

Managerial economics is pragmatic and essentially an applied branch of knowledge. In economic theory many
abstract issues are analyzed on the basis of assumptions which are highly unrealistic. Managerial economics,
avoids difficult abstract issues. It is mainly concerned with analytical tools that are useful to firms.

5.1.4ELECTIVE IN NATURE
Managerial economics is integrative or elective in nature. It combines and synthesizes ideas and methods from
various functional fields of business administration like accounting, production management, marketing and
finance. Thus it is multi-disciplinary in dimension.

5.1.5NORMATIVE

Managerial economics is prescriptive in character. It recommends what should be done under various alternative
conditions. Managerial economists are generally preoccupied with the optimum allocation of resources among
completing ends wit h a view to obtaining the maximum benefit according to pre-determined criteria. To achieve
these objectives, they do not assume that all other things would remain equal,but try to introduce policies which
if implemented would achieve the desired results. Thus managerial economics is both light giving and a fruit-
bearing one.

Managerial economics and other disciplines


Managerial economics is closely related to other disciplines and frequently impinges upon their fields.

Managerial economics and economics


Micro economics is also known as partial equilibrium analysis deals with the problem of individuals, firms and
industries and is the main source of inspiration to managerial economics. Concepts like elasticity, marginal
revenue, marginal cost, and models, like price leadership, kinked demand curve and price discrimination are
made use of in managerial economics spring from micro economic theory.

Macro economics aids managerial economics in the area of forecasting. The aggregates of the economics system
such as Gross National Product, General Price Index and level of employment serve as a useful guide for
devising relevant business policies.

Managerial economics and Statistics


Statistics provides many tools to Managerial economics. It is highly useful in demand forecasting. A correct
estimate of demand is vital for the management in framing a suitable inventory policy. Statistical tools like
averages, dispersion, correlation, regression, time series etc are extensively applied in various managerial
aspects.

Managerial economics and Mathematics


Operations research is the ‘’ application of mathematical techniques in solving business theory, input-output
analysis, queuing and simulation are some of the techniques developed by operational researchers. These
techniques are applied in Managerial economics.

Managerial economics and Accounting


Managerial economics is also related to accounting. For example, the profit and loss statement of a firm will
furnish necessary information to the manager to identify the specific areas of loss and arrive at suitable
decisions. It is very much useful in cost control.

Managerial economics and decision making


The theory of decision making too, has a significant place in managerial economics. It deals with the selection of
a particular course of action among the various alternatives. In order to choose a particular course of action,
many factors are taken into accounts. Sociological and psychological factors are considered and weighted
against economic factor in arriving at a decision.

7. ROLE OF A MANAGERIAL ECONOMIST IN BUSINESS

A managerial economist has a significant role to play in business by assisting the managements in their
successful decision making and forward planning goals. The factors which influence the business over a period
may lie within the firm or outside the firm. In general, these factors can be divided into two categories. (1)
External and (2) Internal
The external factors lie outside the control of the management because they are external to the firm and are said
to constitute the business environment. The internal factors lie within the scope and operations of a firm and
hence within the control of the management and they are known as business operations.

EXTERNAL FACTORS

The function of a managerial economist is to analyze the environmental factors and recommend suitable
policies. The following are the important external factors affecting the firm.

General Economic Conditions

The most important external factor is the general economic conditions of the economy such as business cycles,
competitive conditions of the market, size and the rate of growth of the national income, the regional pattern of
income distribution, influence of globalization on the domestic economy etc. it is the duty of the managerial
economist to gather and analyze information with regard to these changes, and advise the management regarding
their likely effects on the operations of the firm and recommend suitable ways to pursue the organizational
goals.

Nature of Demand

The second important external factor relates to the nature of demand for the product. Since purchasing power is
an important variable influencing demand, the managerial economist has to study the purchasing power trend in
general an din the region concerned in particular. Moreover, it is his function to observe whether fashions, tastes
and preferences undergo any change and whether it is likely to have an impact on the demand for the product.
Input Cost

The third external factor influencing the firm is the input cost of the firm. The managerial economist has to
advise the management on labour market conditions i.e., the cost of labour in different occupations. He also
studies the money market conditions, the changing scenario in government’scredit policy and possible ways of
achieving the least-cost combination of factors and so on.

Marketing

Buying of raw materials and selling of finished goods are two important aspects of marketing. The managerial
economist has to study the markets from where the firm is buying its raw materials and selling its finished
goods. The understanding helps him to evolve and frame a suitable price policy for the firm.

Market share

Market share refers to the share of a firm in the industry for a particular product. Expansion of market share is a
good symptom of growth. Therefore, the managerial economist has to examine the opportunities and strategies
which help in the expansion of the firm’s share in the regional and international markets.

Economic policies
Last, but not the least, the managerial economist must keep in touch with the government’s monetary policy,
fiscal policy, industrial policy, budgetary policy trends

etc. to advice the management.

INTERNAL FACTORS

A managerial economist can also be helpful to the management in making decisions relating to the internal
operations of the firm. The analysis of cost structure, and forecasting of demand are very essential. Moreover, it
is his responsibility to bring about a synthesis of policies relating to production, investment, inventories and
price.

SPECIFIC FUCTIONS

It involves

I. Sales forecasting
II. Industrial market research
III. Economic analysis of competing companies
IV. Pricing problems of industry
V. Capital projects
VI. Production programmes
VII. Security management analysis
VIII. Advice on trade and public relations
IX. Advice on primary commodities
X. Advice on foreign exchange management
XI. Economic analysis of agriculture
XII. Analysis on underdeveloped countries
XIII. Environmental forecasting etc.

APPLICATION OF THE THEORIES OF ECONOMICS IN BUSINESS DECISIONS

The following are the main theories in economics that help the firm in decision-making process.

THEORY OF DEMAND
Demand theory explains the consumer’s behavior. The theory helps to understand the behavior of
consumers when the determinants of demand such as income, taste and fashion, prices of substitutes, etc
change. A knowledge of demand theory is vital in the choice of commodities for production.

THEORY OF PRODUCTION
The BASIC function of a firm is to produce goods and services and sell them in the market. Production
requires employment of various factors of production. The factors are substitute among themselves to a
certain extend. To maximize production and profit, it is necessary to achieve the least-cost combination
of factors. Production theory is of immense use in determining the size of the firm, the size of the total
output and the optimum factor combination.

THEORY OF PRICE
Price theory explains price determination under various different market structures like perfect
competition, monopoly, oligopoly, etc. It is also useful to determine the optimal advertisement budget
that is necessary to maximize sales.

THEORY OF PROFIT
Profit making is the basic objective of business concerns. But, making a satisfactory level of profit is not
always certain, due to the presence of risk and uncertainty in business operations. Some of the factors
which influence profit are (i) nature of demand for the product (ii) prices of the inputs in the factor market
and (iii) the degree of competition in the factor market . An element of risk is always there, even if
business activities are systematically planned .Therefore, minimising risks is of paramount importance to
safeguard the welfare of the firms. Profit theory guides in the measurement of profit and in estimating a
reasonable return on the capital employed.

THEORY OF CAPITAL AND INVESTMENT


Capital like all other inputs, is scare and an expensive factor. Rational utilisation of scarce resources is
one of the important tasks of the managers. The major issues related to capital are (i) assessing the
efficiency of capital (ii) choice of investment projects(iii) the most efficiency allocation of capital
.Knowledge of capital theory can contribute a great deal in investment decisions ,choice of projects,
maintaining capital intact ,capital budgeting etc.

MACRO ECONOMIC THEORIES


Though managerial economics is basically micro in nature, macro theories are altogether irrelevant for
decision –making at the firm level. This is because, the macroeconomic environment, which includes the
behaviour of national aggregates such as priced level , national income , unemployment, poverty and,
microeconomic policy aspects, such as economic policy aspects, such as economic policy ,industrial
policy subsidies ,administered prices and controls licensing policy ,etc affect firms decisions.

XIV.

CHAPTER 2
OBJECTIVES OF BUSINESS FIRMS

INTRODUCTION

The sole and only objective in the traditional theory of the firm has been profit maximization.this objective
occupied the centre stage of economictheories till 1939 when R.L. Hall and C.J. Hitch with the help of their
empirical studies,challenged both the profit maximization and the marginalistic behavioural rules.

THE FIRM AND ITS OBJECTIVES

A firm is a technical unit in which commodities are produed for sale to other economic units like
individuals,households,firms and government bodies.

MAXIMISATION OF PROFIT

The traditional economic theory assumed profit maximization as the sole objective of the firm.Under perfect
competition, the price of a commodity is determined by the forces of demand and supplay.Since the firm is one
among the many firms.,its action has no perceptibleinfluence on price and supply.The firm is a price taker and a
quantity adjuster.That is ,by accepting the market price the firm can sell any amount of product it likes.The
difference between the total revenue and total cost is the economic measure of profit.It is the residue that is left
after payment to all factors of production have been made.
SALES MAXIMISATION

Baumol’s theory of sales maximisation is an alternative theory of a firm’s behaviour.The hypothesis rests on the
separation of ownership and management found in firms.Being a consultant to a number of firms in America ,he
points out that most managers seek to maximize their sales revenue rather than profits.He argue that the
managers in oligopolistic markets must earn a minimum level of profits to keep the share holders satisfied and
only after that ,they may pursue other things.In simple terms Baumol’s sales maximization hypothesis suggests
that the maximization of sales revenue subject to a profit constraint may be a more likely goal of large businees
firms than the mere assumption of profit maximization.

SECURITY OF PROFIT
According to prof:Rothchild the main aim of a firm is not profit maximization ,but a steady flow of profit for a
long time.In other words, it is interested in getting secure profits for a long period of time rather than profit
maximization.

Rothchild argues that the objectives of profit maximisation is valid only under conditions of perfect competition
or monopolistic competition,where there are a large number of firms.This is true under true monopoly also.In
these forms of market, problem of security does not arise.For the pure monopolist ,security against competition
is ensured by virtue of his monopoly power.And for a small competitor the security question is a very urgent
one;the market conditions have such an overwhelming force that he alone cannot do anything to safeguard his
position.Maximisation of profits is therefore a legitimate generalization about their behaviou of an entrepreneur
in such cases.

But Rothchild points out that in the field of duopoly and oligopoly this assumption is no longer valid.Under
oligopoly,a firm is not motivated by profit maximization.It is engaged in a constant struggle to achieve and
maintain a secure poition in the market,like a military strategit.
MAXIMISATION OF SATISFACTION
Prof;Scitovsky favours satisfaction maximization in the place of profit maximization.According of Scitovsky
the satisfaction of an entrepreneur does not depend only upon the material goods in the form of comforts and
necessaries obtained by him out of the profits due to his entrepreneurial activity.It includes the leisure or what
Hicks calls aquiet life’ also as an essential ingredient of individual welfare.

Scitovskyargues that an entrepreneur would profits only.if his choice between more income and more leisure is
independent of his income.If an entrepreneur works more,less time will be available to him for leisure therefore
the satisfaction and keep his effortsand output below the level of obtaining maximum profits.

UTILITY MAXIMISATION

Oliver E.Williamson has developed the managerial utility hypothesis,managers seek to maximize their own
utility function,subject to a minimum leval of profit.A minimum leval of profit is necessary to satisfy the
shareholders or to keep the managers position unchanged. The utility of the self seeking managers depends
upon three factors.1)no.of persons working as subordinates,known as staff ,2)perquisites enjoyed by managers
and,3)discretionary powers to sanction investment project.Thus the hypothesis states that a long as a firm
earnsprofit which meet the minimum requirements of the owners,managers seek to maximize their own utility
functions.

SATISFICING
Prof Herbert Simon has developed a theory which emphasizes that the objective of a firm is not profit
maximization but satisficing.According to Simon,the firms may prefer the quite life and may be satisfied in
achieving a certain minimum level of profits,a certain share of the market or certain leval of sales.
GROWTH MAXIMISATION
According to Marris the main goal of a firm is the balanced rate of growth of the firm.It means the maximization
of the rate of growth of demand for the products of the firm and the rate of growth of its capital supply.By
maximizing these variables,managers maximize their own utility functions and also the owners’ utility functions.

OTHER POSSIBLE OBJECTIVES


Papandreou says that organizational objectives grow out of an interaction among the various participants in the
organization.this interaction produses a general preference function.

Cooper argues that business attempt to maintain liquidity sufficient”s to assure the firm’s financial position,

3. DECISION MAKING

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

Most of the economic theories are based on perfect knowledge which implies certainty. In real life, a firm
may experience uncertainty regarding market trends, reaction of competitors, and of government policies. In
fact, most decisions have to be made under varying degrees of risk and uncertainty. Risk refers to a situation
where there is more than one possible outcome to a decision and the probability of each specific outcome is
known or can be estimated. Uncertainty is the case where there is more than one possible outcome to a decision
and the probability of each specific outcome occurring is not known. The ability of an efficient manager lies in
taking a correct decision when the information and time available are limited.

The following chart depicts the process of decision-making.


Alternative Selection of a Execution of Result of Action
courses of Action particular Action Action

Full realization of
objective
Action A Decision A chosen
making plan of
Action B Partial realization
Action
of objective
Action C

Non-realization of
objective

Now the question is how to take a decision. Since the knowledge of the future uncertain the managements have
to make decisions daily and also formulate plans for the future. There are various ways in which decisions can
be made, ranging from ‘off the cuff’ guess work to fully informed conclusions combined with good judgement.
Mainly there are five fundamental concepts that are used in decision making viz.,

i. Incremental concept

ii. The concept of time perspective

iii. The discounting principle

iv. The concept of opportunity cost and

v. The principle of equi-marginalism

4. FUNDEMENTAL CONCEPTS USED IN MANAGERIAL

ECONOMICS

Five fundamental concepts that are basic in study of managerial economics are as follows:

1. The incremental concept


2. The concept of Time perspective

3. The Discounting principle

4. The concept of opportunity cost

5. The principle of equi-marginalism

4.1. The Incremental Concept

Incremental concept is closely related to the marginal revenues and marginal cost of economic theory.
Incremental reasoning involves estimates of the impact of decision alternatives on costs and revenues, stressing
the changes in total costs and total revenue that result from changes in price, products, procedures, investments,
or whatever may be at stake in the investment decision.

The two basic concepts involved in this analysis are incremental cost and incremental revenue.
Incremental cost is the change in total cost consequent upon a decision. Likewise incremental revenue is the
change in total revenue due to decision.

The decision criterion according to this concept is “Accept a particular decision if it increases the revenue
more than it increases the cost, as assessed from the managerial point of view”.

Other variants of this principle are: if:

i. It decreases some costs to a greater extent than it increases others

ii. It increases some revenues more than it decreases others: and

iii. It reduces costs more than revenues

4.2. Implications of Incremental Reasoning

Incremental reasoning is significant, for some business hold an erroneous view that to make an overall profit
they must make a profit on every job. The result is that they often refuse orders that do not cover

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Full cost (labor, materials and overhead) plus some provision for profit. But incremental reasoning shows that
this rule may be inconsistent with profit maximization in the short run. It can be seen from the following
illustration that a refusal to accept business below full cost means a rejection of a possibility of adding more to
revenue than to cost.

Illustration

Suppose a new order is estimated to bring in Rs. 20,000 by way of additional revenue. The cost as estimated by
the company’s accountant is as follows:

Labor………………………………………………………….Rs. 6,000

Material………………………………………………………...Rs. 8,000

Overhead (allocated at 120% of labor cost) ………………….Rs. 7,200

Selling and administrative expenses

(allocated at 20% of labor and material costs)………………..Rs. 2,800

-------------------------

Full Cost Rs. 24,000

--------------------------

The order appears to be unprofitable, because, if it is accepted it will result in a loss of Rs. 4,000. But suppose
that there exists an idle capacity with this order could met. Further suppose the order adds only Rs. 2000 to
overheads (the incremental overhead is limited to the added use of heat, power and light, the added wear and tear
to the machinery, the added costs of supervision etc). The order does not require any selling and administrative
costs, as the only requirement is the acceptance of the order. In addition, only a part of the labor cost is
incremental because some of the idle workers already on the pay roll will be employed without any additional
pay

The incremental cost of accepting the above order may be as follows:

Overheads……………………………………………………….Rs. 2,000

Materials…………………………………………………………Rs. 8,000

Labor………………………………………………………… Rs. 4,000

----------------------------------

Total incremental cost Rs. 14,000


Therefore, contrary to the accountant’s estimate of a loss of Rs. 4,000 the order will result in an addition of Rs.
6,000 as profit. The application of the incremental principle maximizes short run profit, but not long-run profit.

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4.3. The Concept of Time Perspective

Economists make a distinction between short-run and long-run with a precision that is often missed in ordinary
discussions. This distinction is not based on the duration of time but on the ability of the business firms to
change the use of the different inputs such as raw material, labor, management, plant and equipment etc.

If firms can change the ratio in which every input is used, the period is referred to as the long run. On the
other hand, if firms can change the use of a few inputs but not all, the period is referred to as the short run.

In real life this type of dichotomy between long-run and short-run perspectives breaks down. In many
decisions as the time perspective is extended more and more items of costs become variable. Revenue items also
are likely to change as the time perspective moves out farther. The crucial problem in decision-making is to
maintain the right balance between the short run and long run and intermediate run considerations, but may as
time passes, have long run repercussions that make it more of less profitable than it seemed at first. The
following illustration may make the matter clear.

Consider a firm with some temporary idle capacity. An order for 10,000 units comes to the management’s
attentions. The prospective consumer is willing to pay Rs. 4 per unit or Rs. 40,000 for the whole lot. The short
run incremental cost (which ignores the fixed cost) is only Rs. 3 . Therefore, the contribution to overhead and
profit is Re.1 per unit (or Rs. 10,000 for the whole lot). In spite of this favorable position, before accepting this
order, the management must take into consideration the following long run repercussion viz.,

1. Firstly, if the management commits itself to a series of repeat orders at the same price the management
may be forced to consider the question of expansion of capacity when the so called fixed costs may also
become variable.

2. Secondly, the acceptance of an order at a lower price might tarnish the image of the company.

3. Thirdly, some of the present customers may feel that they had been treated unfairly and may opt to resort
to firms which follow ‘ethical pricing’.
The above considerations lead us to following conclusion. A decision should take in to account the short run and
long run effect on revenue and cost, customer reaction and company’s image etc, giving appropriate weight to
the most relevant time periods.

The Discounting Principle

Money has a time value. A certain sum of money, say Rs 1000 to be received today is worth more than Rs
1000 to be received in future. But how much is it worth depends upon two factors which are, (1) The time
interval (2) The time pattern

The proverb ‘A bird in the hand is worth two in the bush’ is applicable to this concept. Suppose a person
is offered a choice whether to receive Rs 1000 today or Rs 1000 next year. Naturally he will choose the first
offer for two reasons.

First, the amount can be invested and made to earn interest. Second, a lot of risk and uncertainty is involved in
recovering the amount in future. Considering these, business firms always prefer receiving a given amount that
day itself to receiving the same amount in future.

Investment in business leads to an accrual of benefits over a period of time. The computation of the
present value of an amount due in future or stream of earnings likely to accrue in future, involves discounting of
time.

Suppose we have Rs.2,000 at our disposal. We can invest this amount in a bank, say at an interest rate, ‘r’
of 10%. After one year, we could withdraw from the bank both the original deposit and the accumulated interest;
this would be our future receipt in year one, or R1.

That is, R1= Rs2000 + (0.1)2000 =Rs 2200

Generally R1=PV +r(PV) = PV(1+r)

Where PV = present value

Alternatively if we do not withdraw the money but leave it on deposit for a further period of one year,
then at the end of the second year we could withdraw the following.

R2 = R1 +r(R1) = R1(1+r) = PV(1+r)2

In this manner, R at the end of year ‘n’


Rn = PV(1+r)n

This process is called compounding. The above compound interest formula tells us about the magnitude of
a future receipt if we already know its present value and the interest rate.

The reverse procedure, where the future receipt and the interest are known, and the present value can be
found out. It is known as discounting.

The discounting formula can be stated as:

PV =Rn(1+r)n

This gives us the PV of a sum of money to be received ‘n’ years hence, at a given discount rate of ‘r’. When a
stream of future receipts is expected, to accrue at annual intervals, then the PV of a stream is the sum of the PVs
of each receipt. That is

R1/(1+r) + R2/(1+r)2+ R3/(1+r)3..................+ Rn/(1+r)n

Suppose a firm is going to receive Rs 20000 per year for the next three years at a rate of 10% from its fixed
deposit. Then

PV= 20000/(1+0.10) + 20000/(1+0.10)2+20000/(1+0.10)3

= 20000/1.10 + 20000/1.21 + 20000/1.301

= 18180.2 + 16529 + 15026.2 = Rs 49735.4

The Concept of Opportunity Cost

The concept of opportunity cost lies at the heart of all managerial decisions. The opportunity cost of anything is
the alternative that has been forgone. This implies that one commodity can be produced only at the cost of
foregoing production of the other.

Smith has observed, if the hunter can bag a deer or a beaver in the course of a single day, the cost of a deer is a
beaver and the cost of a beaver is a deer”.

In managerial economics, opportunity costs are the costs of displaced alternatives. They represent only
sacrificed alternatives. According to Haynes, Mote and Paul.

1. The opportunity cost of funds tied up in one’s own business is the interest that could be earned on those
funds in other ventures.
2. The opportunity cost of the time one puts in his own business is the salary he could earn in other
occupations.

3. The opportunity cost of using a machine to produce one product is the sacrifice of earnings that would b
possible from producing other products.

4. The opportunity cost of using a machine that is useless for any other purposes is nil, since its use requires
no sacrifice opportunities.

4.6The Principle of Equi-Marginalism:

According to this principle, if an input can be used in producing goods or services, the allocation of the input
should e such that its marginal contribution is the same in all its uses.

Let us explain this concept with an example. Suppose a firm is engaged in 4 activities –A,B,C and D. All these
activities require the services of labour. Imagine that the firm has 100 units of labour at its disposal, and this is
fixed , as the total pay roll is predetermined. The firm can enhance any one of its activities by adding more
labour but only at the cost of labour in its other activities. The optimum will be attained when the value of the
marginal product of labour its equal in all activities.

Symbolocally

VMPla=VMPb=VMPlc=VMPld where

VM P=value of the marginal product.

L=labour

A,B,C and D=Activities.

This concept of equi-marginalism is crucial in capital budgeting , where the limited resources of the firm have to
be allocated in a rational manner. The equi-marginalism concept holds good only in cases of diminishing
returns.

REVIEW QUESTIONS:

1. Define decision-making?

2. What are the fundamental concepts that aid the decision-making process?
3. What are the objectives of a business firm

4. State the incremental concept and explain its importance.

5. Briefly explain the 5 principles which are basic to the entire gamut of managerial economics.

6. What is opportunity cost? How is it calculated?

7. Show that the principle of ‘Equi-Marginalism’ is the extension of the condition of equilibrium of a
consumer.

8. Write short notes on

a. Discounting principle

b. Marginalism

c. Steps in decision-making