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Managerial Economics (UM14MB501)

Unit 1 : Introduction

Dr. Sujay Sathyanarayana


Sujaybs54@gmail.com
Lecture 1
• Introduction to Managerial Economics
• Meaning
• Nature
• Scope & Significance.

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Economics

• Derived from Greek word “oikonomikós” which means “relating to household


management”

• Economics is a social science that studies production, distribution and


consumption of goods and services. Also, how individuals, governments, firms
and nations make choices on allocating scarce resources to satisfy their
unlimited wants and coordinate efforts to achieve maximum output.

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Broad Classification of Economics
Macroeconomics

Macroeconomics studies the overall economy. This can include a distinct geographical
region, a country, a continent or even the whole world.
• Monetary and fiscal policy. e.g. what effect does interest rates have on whole economy?
• Reasons for inflation, and unemployment
• Economic Growth
• International trade and globalization
• Reasons for differences in living standards and economic growth between countries.
• Government borrowing

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Microeconomics

Microeconomics focuses on how individual consumers and producers make their


decisions. This includes a single person, a household, a business or a governmental
organization.
• Microeconomics ranges from how these individuals trade with one another to how
prices are affected by the supply and demand of goods.
• Efficiency and costs associated with producing goods and services
• Individual consumer behavior. e.g. Consumer choice theory
• Individual labour markets – e.g. demand for labour, wage determination (how
labor is divided and allocated).
• Externalities arising from production and consumption.
Approaches in studying Economics
Normative: is a part of economics that expresses value or normative judgments about
economic fairness or what the outcome of the economy or goals of public policy ought to be.

An example of a normative economic statement is as follows:

“The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save
the family farm”.

This is a normative statement, because it reflects value judgments. This specific statement makes
the judgment that farmers deserve a higher living standard and that family farms ought to be
saved.

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Positive economics

• Positive economics is the branch of economics that concerns the


description and explanation of economic phenomena. It focuses on facts and
cause-and-effect behavioral relationships and includes the development and
testing of economics theories.
Example:
"The unemployment rate in France is higher than that in the United States."

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Managerial Economics
Managerial economics is the study of how scarce resources are directed most
efficiently to achieve managerial goals. It is a valuable tool for analyzing
business situations to take better decisions.
• Production analysis – microeconomic techniques are used to
analyze production efficiency, optimum factor allocation, costs, economies of
scale and to estimate the firm's cost function.
• Pricing analysis – microeconomic techniques are used to analyze
various pricing decisions including transfer pricing, joint product
pricing, price discrimination, price elasticity estimations, and choosing the
optimum pricing method.

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Nature of Managerial Economics

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Managerial Decision Making Process

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Roles and Responsibilities of Managerial Economics
• To make a reasonable profit on capital employed: He must have a strong conviction that
profits are essential and his main obligation is to assist the management in earning
reasonable profits on capital employed in the firm.
• He must make successful forecasts by making in depth study of the internal and external
factors
• He must inform the management of all the economic trends: A managerial economist should
keep himself in touch with the latest developments of national economy and business
environment so that he can keep the management informed with these developments and
expected trends of the economy
• He must earn full status in the business and only then he can be helpful to the management in
good and successful decision-making
For this: (i) He must receive continuous support for himself and his professional ideas by
performing his function effectively. (ii) He should express his ideas in simple and
understandable language with the minimum use of technical words, while communicating with
his management executives.

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Relation of Managerial Economics with Other Domain
• Statistics
• Accounting
• Operations Research.

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Statistics & Managerial Economics
• Statistical techniques are used in collecting processing and analyzing
business data, testing and validity of economics laws with their economic
phenomenon before they are applied to business analysis.
• The statistical tools for e.g. theory of probability, forecasting techniques, and
regression analysis help the decision makers in predicting the future course
of economic events and probable outcome of their business decision.
• In order to base its price decision on demand and cost consideration, a firm
should have statistically derived or calculated demand and cost function.

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Accountancy & Managerial Economics
• Managerial economics has been influenced by the developments in
accounting techniques.
• A proper knowledge of accounting techniques is very essential for the
success of the firm because profit maximization is the major objective of the
firm.
• Managerial Economics requires a proper knowledge of cost and revenue
information and their classification.

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Operations Research & Managerial Economics
• Linear programming and goal programming are two widely used OR in business
decision making. It has influenced ME through its new concepts and model for
dealing with risks.
• The significant relationship between ME and OR can be highlighted with
reference to certain important problems of ME which are solved with the help of
OR techniques, like allocation problem, competitive problem, waiting line
problem, and inventory problem..

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Opportunity Cost
“The cost of an alternative that must be forgone in order to pursue a certain
action. Put another way, the benefits you could have received by taking an
alternative action.”

Ex: if a gardener decides to grow carrots, his or her opportunity cost is the
alternative crop that might have been grown instead (potatoes, tomatoes,
pumpkins, etc.)

Another one: as an economy tries to increase the production of good X , such as


cameras, it must sacrifice more of the other good, Y, such as mobile phones.

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Exercise on OC
1. Robinson Crusoe & Friday are on a deserted island. Neither requires sleep and
there are 24 hours in the day. On the island there are 2 activities; fishing and
catching rats which are both eaten raw. Crusoe & Friday work alone. Crusoe can
catch 1 fish or 2 rats per hour. Friday can catch 6 fishes or 4 rats per hour. Neither
likes eating rats but understands that for a health reasons each needs to eat a
minimum of 24 rats per day for a “balanced diet”.
a. Find the opportunity cost of fish and rats for Crusoe and Friday.
b. Draw the production possibility curves for Crusoe and Friday and show that
each can attain the balanced diet by consuming what they catch.

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Find the opportunity cost of fish and rats for
Robinson and Friday? Fish = 1/hr Rats= 2/hr
Fishing Catching Rat Fish Rats OC for Fish OC for Rate
(Hrs) (Hrs)
0 24

1 23

2 22

3 21

4 20

12 12

24 0
Robinson-OC
Friday-OC
Production Possibility Curve

A curve indicating a trade-off between goods and


services and maximum combination of them that can
be produced with available resources (Parkin et.al,
2014, pp.32)
Production Possibility Curve (PPC)
Production Possibility Curve (PPC)

• PPC is a graph representing production tradeoffs of


an economy given fixed resources.

• all points on the curve are points of


maximum productive efficiency. (A,B,C,D,E,F)

• all points inside the frontier (such as X) can be


produced but are productively inefficient;

• An outward shift of the PPF results from growth of


the availability of inputs such as physical capital or
labour, or technological progress (such as Y)

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Diminishing Marginal Utility Concept

• “The additional benefit which a person


derives from a given stock of a thing
diminishes with every increase in the
stock that he already has.” – Marshall
• “As the amount consumed of a good
increases, the marginal utility of the
goods tends to decrease.” - Samuelson

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Basic Mathematical Tools

• Functions
• Variables
• Equations
• Graphs
• Slope

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What is a Function ?
Function is the relationship between the variables.
Let x and y be two variables and if the value of the variable y depends upon the value of
the variable x, we say that y is a function of x and we can writes it symbolically as
y=f(x)
Example: f(x) = x/2 is a function then

• f(2) = 1

• f(16) = 8

• f(−10) = −5

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Function – Demand Curve (Straight Line) D = 25 – 3P

• Variables are Demand and Price; Dependent variable - is


the Demand and Independent variable - is the price
• For instance, if price changes from P = 0 to P = 1, Demand
changes from 25 to 22 Units.

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Equations
• Linear equation : First degree – independent variables are raised to power
one only.
• Example : ax + b=y

• Quadratic equation : Second degree – at least one independent variable is


raised to power two.
• Example : ax2 + bx + c = y

• Cubic equation : Third degree – at least one independent variable is raised to


power three.
• Example : ax3 + bx2 + cx + d = y

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Incremental Principle and Decision Rule
• Total Revenue: denoted as (TR), quantity of commodity sold (q) multiplied by
price per unit of output (P)
Therefore, Total Revenue = price per unit * quantity sold
TR = P*q
• Average Revenue: denoted as (AR), total revenue (TR) by the quantity sole (q)
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Therefore, Average Revenue = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑜𝑙𝑑

AR= R/q

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Incremental Principle….cont…
• Marginal Revenue: denoted as (MR), represents the changes in total revenue
(TR) due to change in one of output sold (q). That is, additional revenue
generated by selling one more unit of a commodity.
• MR function is first derivative of TR function
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Marginal Revenue (MR) = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

MR= dR/dq (Marginal Revenue function)

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Incremental Principle….cont…
Cost Function
• Total Cost (TC) – is the sum of expenditures incurred by a firm in producing a
given level of output
For instance: if ‘x’ is the quantity produced by a firm at total cost ‘c’, then the
total cost function
TC = f(x)
• Average Cost (AC) – cost per unit is obtained by dividing the total cost by the
quantity produced (x)
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝐶
Therefore, AC = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡 or AC = 𝑥

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Incremental Principle….cont…
• Marginal Cost (MC) – is the rate of change of total cost (TC) for one unit
change in output (x). In other words, marginal cost represents the changes in
the total cost for each additional unit produced.
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
Therefore, MC = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡

MC= dC/dx (Marginal Cost function)

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Numerical
1. The total cost of producing 100 units is Rs 2500. and that of 101 units is Rs
2550, calculate the Marginal Cost.
2. A company’s total revenue by sale of 100 units is Rs 3800. and that of 101
units is Rs 3900, calculate the Marginal Revenue.
3. If TR=300+4Q2, find the MR.
4. If TC=2800+Q+2Q2, find the MC.
5. The Price function is given by P=500-5Q , Find the total revenue if the total
production is 10 units.

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Incremental Principle

This principle is applied to make business decisions which involves bulk


production and a large increase in ‘total cost’ and ‘total revenue’. Such increase
in the cost or revenue is called incremental cost or incremental revenue,
which is further to ‘incremental output’.

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Incremental Cost
• Incremental cost is defined as the costs that arise due to a business decision.
For instance: suppose a firm decides to increase production by using more inputs
or by adding a new plant to the existing capacity. This decision increases the
firm`s total cost of production from $100 million to $ 115 million. Then, $15
million is the incremental cost.
Thus, an increase in the total cost of production due to a business decision is
incremental cost.

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Incremental Revenue
• Incremental revenue, is the increase in revenue due to business decision.
When a business decision is successfully implemented, it does result in a
significant increase in its total revenue.
For instance: the firm`s total revenue increases, let us suppose, from $130
million to $ 150 million. Thus, post-decision, total revenue increased by $20
million.

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Incremental Reasoning
• The use of incremental concept in the business decisions is called
incremental reasoning.
• For instance: in the above example, the firm is considering to install new
plant because incremental cost is lesser than the incremental revenue. That
is, incremental cost to setup new plant is $15 million and revenue generated
is $ 20 million. The incremental cost exceeds the incremental revenue by $ 5
million, which means return is around 33.3 percent.

• Note: the firm will accept this business proposition provided there is no
better business proposition available to the firm.

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Equi-Marginal Principle
• The equi-marginal principle was originally associated with consumption
theory and the law is called ‘the law of equi-marginal utility’
• It states that a utility maximizing consumer distributes his consumption
expenditure between the various good and services equal because marginal
utility derived from each unit of expenditure on various goods and services is
the same.
• This pattern of distribution of consumption expenditure maximizes a
consumer`s total utility.

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