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7/28/2016

Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained!

Managerial
Economics: 6 Basic
Principles of
Managerial
Economics –
Explained!
by Smriti Chand

ADVERTISEMENTS:

Introduction:
Managerial Economics is both conceptual
and metrical. Before the substantive
decision problems which fall within the
purview of managerial economics are
discussed, it is useful to identify and under​
stand some of the basic concepts underlying
the subject.
Economic theory provides a number of con​
cepts and analytical tools which can be of
considerable and immense help to a
manager in taking many decisions and
business planning. This is not to say that
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The Opportunity Cost Concept 4. The Discounting Concept 5. There are six basic principles of managerial economics. The Incremental Concept 2. The Concept of Time Perspective 3. Therefore. Risk and Uncertainty 1. They are: Content: 1. The Incremental Concept: http://www. In fact. it would be useful to examine the basic tools of managerial economics and the nature and extent of gap between the economic theory of the firm and the managerial theory of the firm. actual problem solving in business has found that there exists a wide disparity between economic theory of the firm and actual observed practice. The contribution of economics to managerial economics lies in certain principles which are basic to managerial economics.yourarticlelibrary.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 2/17 .7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! economics has all the solutions. The Equi-marginal Concept 6.

yourarticlelibrary. whereas incremental revenue means change in total revenue resulting from a decision of the firm. Incremental concept is closely related to the mar​ ginal cost and marginal revenues of economic theory. Incremental cost denotes change in total cost.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 3/17 . The incremental principle may be stated as follows: A decision is clearly a profitable one if (i) It increases revenue more than costs. they must make a http://www. Illustration: Some businessmen hold the view that to make an overall profit. The two major concepts in this analysis are incremental cost and incremental revenue. (iv) It reduces costs more than revenues. (iii) It increases some revenues more than it decreases others.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. (ii) It decreases some cost to a greater extent than it increases others.

000 http://www. then the actual incremental cost is as follows: Labour Rs. For it results in a loss of Rs. 1. This will lead to rejection of an order which prevents short run profit. 3.000.400 Full Cost Rs. 000 The order appears to be unprofitable.000 Materials Rs.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! profit on every job. 10. 1. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed without added pay and no extra selling and administrative costs. However. 4.000.yourarticlelibrary. 2. A simple problem will illustrate this point. suppose there is idle capacity which can be utilised to execute this order. 3. The result is that they refuse orders that do not cover full costs plus a provision of profit. 2.000 Overhead charges Rs.12. Suppose a new order is estimated to bring in an additional revenue of Rs.600 Selling and administrative expenses Rs.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 4/17 . and Rs. If order adds only Rs.000 to overhead charges. The costs are estimated as under: Labour Rs.

000 Total Incremental Cost Rs.000 Thus there is a profit of Rs. 3. The concept is mainly used by the progressive concerns. Concept of Time Perspective: The time perspective concept states that the http://www. 7.000.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! Materials’ Rs. 4. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs. Even though it is a widely followed concept. (b) The concept can be applied only when there is excess capacity in the concern.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 5/17 . 1.yourarticlelibrary. The order can be accepted on the basis of incremental reasoning. it has certain limitations: (a) The concept cannot be generalised because observed behaviour of the firm is always vari​ able. (c) The concept is applicable only during the short period. 2.000 Overhead charges Rs.

In the long period. In the short period.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 6/17 . In the short period. The main problem in decision making is to establish the right balance between long run and short run. the firm can change its output by changing its size. The economic concepts of the long run and the short run have become part of everyday language. the average cost of a firm may be either more or less than its average revenue. In the long period. the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! decision maker must give due consideration both to the short run and long run effects of his decisions. the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. the http://www.yourarticlelibrary. He must give due emphasis to the various time periods. In the long period. the firm can change its output without changing its size. It was Marshall who introduced time element in economic theory. In the short period.

7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! average cost of the firm will be equal to its average revenue. The customer is willing to pay only Rs. If the firm executes this order. (b) The other customers may also demand a similar low price. 000 for the lot). The short run incremental cost (ignoring the fixed cost) is only Rs.000 for the whole lot but no more. received an order for 10.00 per unit (or Rs. the contribution to overhead and profit is Rs. Therefore. http://www.00 per unit or Rs. A decision may be made on the basis of short run considerations. 3. a firm having a temporary idle capacity. it will have to face the following repercussion in the long run: (a) It may not be able to take up business with higher contributions in the long run.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 7/17 . 4. Suppose.yourarticlelibrary. 40.000 units of its product. Illustration: The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared. 10. 1.00.

Therefore. The Opportunity Cost Concept: Both micro and macro economics make abundant use of the fundamental concept of opportunity cost. Haynes. the opportunity cost http://www. 3. the managerial econo​ mist should take into account both the short run and long run effects as revenues and costs.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 8/17 . (2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. we apply the notion of opportunity cost even if we are unable to articulate its significance. Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons: (1) The management realized that the long run repercus​ sions of pricing below full cost would more than offset any short run gain.yourarticlelibrary. (d) The long run effects of pricing below full cost may be more than offset any short run gain. In Managerial Economics.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! (c) The image of the firm may be spoilt in the business community. In everyday life. giving appropriate weight to most relevant time periods.

therefore. Resources are scarce. We cannot have everything we want. Sacrifices may be monetary or real. represents the benefits or revenue forgone by pursuing one course of action rather than another.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! concept is useful in decision involving a choice between different alternative courses of action.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 9/17 . 3. The calculation of opportunity cost involves the measurement of sacrifices. The opportunity cost is termed as the cost of sacrificed alternatives. For the production of one com​ modity. 2. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. We are. The concept of opportunity cost implies three things: 1. we have to forego the production of another commodity. we cannot produce all the commodities. Opportunity cost. Opportunity cost is just a notional idea http://www. therefore.yourarticlelibrary. Opportunity cost of a decision is the sacrifice of alternatives required by that decision. forced to make a choice.

7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! which does not appear in the books of account of the company.. In managerial decision making. It helps in proper allocation of factor resources. В. The firm can increase any one of http://www. 3. C. the concept of opportunity cost occupies an important place. If resource has no alternative use. Equi­Marginal Concept:  One of the widest known principles of economics is the equi-marginal principle.yourarticlelibrary.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 10/17 . then its opportunity cost is nil. 4. It helps in determining relative prices of different goods. А. Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved in five activities viz. It helps in determining normal remuneration to a factor of production. 2. The economic significance of opportunity cost is as follows: 1. D and E. This generalisation is popularly called the equi-marginal. The principle states that an input should be allocated so that value added by the last unit is the same in all cases.

profitable to shift labour from low marginal value activity to high marginal value activity. 70 then it is possible and profitable to shift labour from activity A to activity B. 50 while that in activity В is Rs.e. therefore. the value of the marginal product of labour in activity A is Rs. The optimum is reached when the values of the marginal product is equal to all activities.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! these activities by employing more labour but only at the cost i.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 11/17 . sacrifice of other activities.. the value of the marginal product of labour employed in A is equal to the value of the marginal product http://www. It would be.yourarticlelibrary. thus increasing the total value of all products taken together. An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. L = Labour ABCDE = Activities i. If. for example.e. This can be expressed symbolically as follows: VMPLA = VMPLB = VMPLC = VMPLD = VMPLE Where VMP = Value of Marginal Product..

http://www. for a producer this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses.” This judgment is made not on account of the uncertainty surround​ ing the future or the risk of inflation.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! of the labour employed in В and so on. The equimarginal principle is an extremely practical notion. there is lot of risk and uncertainty in future. 5. This appears similar to the saying that “a bird in hand is more worth than two in the bush. It is behind any rational budgetary procedure. Since future is unknown and incalculable. The principle is also applied in investment decisions and allocation of research expenditures.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 12/17 . For a consumer. Discounting Concept: This concept is an extension of the concept of time perspective.yourarticlelibrary. Similarly. Everyone knows that a rupee today is worth more than a rupee will be two years from now. this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same.

it is advisable to find out its ‘net present worth’. you will select Rs.100 next year i.000 today and Rs. 1.yourarticlelibrary. Naturally.000 today.000 next year. http://www.100 has the present worth of Rs. In technical parlance. That is true because future is uncertain. it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. Suppose. for making a decision in regard to any investment which will yield a return over a period of time. Let us assume you can earn 10 per cent interest during a year. Unless these returns are discounted and the present value of returns calculated. 1. 1.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. You may say that I would be indifferent between Rs. you are offered a choice of Rs.000 today or Rs. 1.e. 1. The following example would make this point clear.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 13/17 . 1. Therefore. it is not possible to judge whether or not the cost of undertaking the investment today is worth. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’..000. Rs. 1.

com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 14/17 .05 = 100/1. the present value of Rs.yourarticlelibrary. The uncertainty is due to unpredictable changes in the business cycle. The formula of computing the present value is given below: V = A/1+i where: V = Present value A = Amount invested Rs.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting. Risk and Uncertainty: Managerial decisions are actions of today which bear fruits in future which is unforeseen.05 =Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) 2 For n years V = A/ (1+i) n 6.24 Similarly. Future is uncertain and involves risk. 100 i = Rate of interest 5 per cent V = 100/1+. 95. http://www.

Uncertainty is not allowed to affect the decisions. But products must attempt to predict the future cost and revenue data of their firms and determine http://www. cost and revenue data of their firms with reasonable accuracy. the consequences of an action are not known immediately for certain. etc. market prices. Firms may be uncertain about production.yourarticlelibrary. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence. Under uncer​ tainty. strategies of rivals. This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 15/17 . Also dynamic changes are external to the firm. they are beyond the control of the firm. Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. The result is that the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured.7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! structure of the economy and government policies.

Plagiarism Prevention 4. The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expec​ tations about cost. Prohibited Content 3.yourarticlelibrary. Image Guidelines 5. Content Guidelines 2. revenue and the environment.com/managerial­economics/managerial­economics­6­basic­principles­of­managerial­economics­explained/28361/ 16/17 . ADVERTISEMENTS: .7/28/2016 Managerial Economics: 6 Basic Principles of Managerial Economics ­ Explained! the output and price policies. the risk attitude and the rate of change of the environment. Content http://www. The probabilities of future events are influenced by the time horizon.  Managerial Economics Before publishing your articles on this site. please read the following pages: 1.

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