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Unit No.2

Managerial Economics:

Managerial economics deals with the application of the economic concepts, theories, tools, and
methodologies to solve practical problems in a business. It helps the manager in decision
making and acts as a link between practice and theory". It is sometimes referred to as business
economics and is a branch of economics that applies microeconomic analysis to decision
methods of businesses or other management units.

Managerial Decisions:

Managerial decision areas includes:

 assessment of investible funds

 selecting business area
 choice of product.
 determining optimum output.
 sales promotion.

Managerial Decision Analysis:

Almost any business decision can be analyzed with managerial economics techniques, but it is
most commonly applied to:

Risk analysis – various models are used to quantify risk and asymmetric information and to
employ them in decision rules to manage risk.

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.

Capital budgeting – investment theory is used to examine a firm's capital purchasing decisions.

Scope of Managerial Economics:

1.Demand Analysis and Forecasting: A business firm is an economic organisation which is

engaged in transforming productive resources into goods that are to be sold in the market. A
major part of managerial decision making depends on accurate estimates of demand. A
forecast of future sales serves as a guide to management for preparing production schedules
and employing resources. It will help management to maintain or strengthen its market
position and profit base.

2.Cost and production analysis: A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing
are cause variations in cost estimates and choose the cost-minimising output level, taking also
into consideration the degree of uncertainty in production and cost calculations. Production
processes are under the charge of engineers but the business manager is supposed to carry out
the production function analysis in order to avoid wastages of materials and time.

3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The
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important aspects dealt with this area are: Price determination in various market forms, pricing
methods, differential pricing, product-line pricing and price forecasting.

4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is
one who can form more or less correct estimates of costs and revenues likely to accrue to the
firm at different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him.

5. Capital management: The problems relating to firm’s capital investments are perhaps the
most complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the capital
assets off are so complex that they require considerable time and labour.

Economic Analysis:

Economic analysis is the most crucial phase in managerial economics. A manager has to collect
and study the economic data of the environment in which a firm operates. He has to conduct a
detailed statistical analysis in order to do research on industrial markets.

Optimization Techniques:
Optimization techniques are very crucial activities in managerial decision-making process.
According to the objective of the firm, the manager tries to make the most effective decision
out of all the alternatives available. Though the optimal decisions differ from company to
company, the objective of optimization technique is to obtain a condition under which the
marginal revenue is equal to the marginal cost.
The first step in presenting optimization techniques is to examine the methods to express
economic relationship. Now let’s have a look at the methods of expressing economic
relationship −

 Equations, graphs, and tables are extensively used for expressing economic
relationships.

 Graphs and tables are used for simple relationships and equations are used for complex
relationships.

 Expressing relationships through equations is very useful in economics as it allows the

usage of powerful differential technique, in order to determine the optimal solution of
the problem.

Now suppose, we have total revenue equation −

TR = 100Q − 10Q2

Substituting values for quantity sold, we generate the total revenue schedule of the firm −

Relationship between total, marginal, average concepts, and measures is really crucial in
managerial economics. Total cost comprises of total fixed cost plus total variable cost or
average cost multiply by total number of units produced

TC = TFC + TVC or TC = AC.Q

Optimization Analysis

Optimization analysis is a process through which a firm estimates or determines the output
level and maximizes its total profits. There are basically two approaches followed for
optimization −
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Total revenue and total cost approach

Marginal revenue and Marginal cost approach

Total Revenue and Total Cost Approach

According to this approach, total profit is maximum at the level of output where the difference
between the TR and TC is maximum.

Π = TR – TC

Marginal Revenue and Marginal Cost Approach:

As we have seen in TR and TC approach, profit is maximum when the difference between them
is maximum. However, in case of marginal analysis, profit is maximum at a level of output when
MR is equal to MC. Marginal cost is the change in total cost resulting from one unit change in
output, whereas marginal revenue is the change in total revenue resulting from one unit
change in sale.

Constrained Optimization:

When there are some constraints on either the values of the decision variables or the objective
function(s) or both, that they are permitted to lie in certain region and are not permitted to lie
in certain other regions, we have constrained optimization.

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Unit No.2

Demand Analysis:

Demand:

Demand is the quantity of goods and services that customers are willing and able to purchase
during a specified period under a given set of economic conditions. The period here could be an
hour, a day, a month, or a year. The conditions to be considered include the price of good,
consumer’s income, the price of the related goods, consumer’s preferences, advertising
expenditures and so on. The amount of the product that the customers are willing to buy, or
the demand, depends on these factors. There are two types of demand. The first of these is
called

Direct Demand:

This model of demand analysis individual demand for goods and services that directly satisfy
consumers desires. The prime determinant of direct demand is the utility gained by
consumption of goods and services. Consumers budget, product characteristics, individuals
preferences are all important determinants of direct demand.

Derived Demand:

Derived demand is the demand resulting from the need to provide the final goods and services
to the consumers. Intermediate goods, office machines are examples of derived demand.

Market Demand Function:

The market demand function for a product is a function showing the relation between the
quantity demanded and the factors affecting the quantity of demand. A demand function for
the good X can be expressed as follows: Quantity of product X demanded = Qx = f (the price of
X, prices of related goods, expectations of price changes, income, preferences, advertising
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expenditures and so on. ) For use in managerial decision making, the relation between quantity
of demand and each demand determining variable must be specified.

Demand Curve:

The demand function specifies the relation between the quantity demanded and all factors
that determine demand. But the demand curve expresses the relation between the price of a
product and the quantity demanded, holding constant all the other factors affecting demand.

Features/Characteristics of Demand

The demand is the specific quantity that a consumer is willing to purchase. Thus, it is expressed
in numbers.

The demand must mean the demand per unit of time, per month, per week, per day.

The demand is always at a price, e. any change in the price of a commodity will bring about a
certain change in its quantity demanded.

The demand is always in a market, a place where a set of buyers and sellers meet. The market
needs not to be a geographical area.

What is Demand Theory:

Demand theory is a principle relating to the relationship between consumer demand for goods
and services and their prices. Demand theory forms the basis for the demand curve, which
relates consumer desire to the amount of goods available. As more of a good or service is
available, demand drops and so does the equilibrium price.

Demand Estimation:

Demand estimation is a process that involves coming up with an estimate of the amount of
demand for a product or service. The estimate of demand is typically confined to a particular
period of time, such as a month, quarter or year. While this is definitely not a way to predict the
future for your business, it can be used to come up with fairly accurate estimates if the
assumptions made are correct.

Pricing:

One of the reasons that companies use demand estimation is to assist with pricing. When you
offer a new product or start a new business, you may not have any idea how to price your
product. When you have an idea of what the demand will be for the product, you know
approximately how much you have to price the product.

Production:

Another reason that demand estimation is commonly used is so that it can help with
production. Before a company puts a large amount of money into producing a product, it can
have an estimate of the demand for that product.

What is Regression Analysis?

Regression analysis is a statistical technique used to find the relations between two or more
variables. In regression analysis one variable is independent and its impact on the other
dependent variables is measured. When there is only one dependent and independent variable
we call is simple regression. On the other hand, when there are many independent variables
influencing one dependent variable we call it multiple regression.
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Simple Regression:

Following are the steps to build up regression analysis −

Specify the regression model

Obtain data on variables

Estimate the quantitative relationships

Test the statistical significance of the results

Usage of results in decision-making

Formula for simple regression is −

Y(dependent variable) = a(Intercept) + b(slope)X(Independent Variable) + u(Random Factor)

Method of Ordinary Least Squares (OLS):

Ordinary least square method is designed to fit a line through a scatter of points is such a way
that the sum of the squared deviations of the points from the line is minimized. It is a statistical
method. Usually Software packages perform OLS estimation.
Y = a + bX

Multiple Regression Analysis:

Unlike simple regression in multiple regression analysis, the coefficients indicate the change in
dependent variables assuming the values of the other variables are constant.

The test of statistical significance is called F-test. The F-test is useful as it measures the
statistical significance of the entire regression equation rather than just for an individual. Here
In null hypothesis, there is no relationship between the dependent variable and the
independent variables of the population.

The formula is − H0: b1 = b2 = b3 = …. = bk = 0

No relationship exists between the dependent variable and the k independent variables for the
population.

Applications of Regression Analysis:

1. Predictive Analysis.
2. Operational Efficiency.
3. Supporting Decision.
4. Correcting Errors.
5. New Insights.

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Unit No.3

Demand Forecasting:

Demand forecasting helps a firm to assess the probable demand for its products and plans its
production accordingly.

Demand forecasting is very important in industrially developed countries where supply position
is at ease and the demand position is always uncertain.
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1. In simple words — “Demand forecasting is an estimate of future sales”.

2. From a Company’s or Firm’s point of view — “Demand Forecasting means deciding in

advance its share in the Total Market Demand”.

Demand Forecasting Techniques:

Survey Method:

Survey method is one of the most common and direct methods of forecasting demand in the
short term. This method encompasses the future purchase plans of consumers and their
intentions.

i. Experts’ Opinion Poll:

Refers to a method in which experts are requested to provide their opinion about the product.
Generally, in an organization, sales representatives act as experts who can assess the demand
for the product in different areas, regions, or cities.

ii. Delphi Method:

Refers to a group decision-making technique of forecasting demand. In this method, questions

are individually asked from a group of experts to obtain their opinions on demand for products
in future. These questions are repeatedly asked until a consensus is obtained.

iii. Market Experiment Method:

Involves collecting necessary information regarding the current and future demand for a
product. This method carries out the studies and experiments on consumer behavior under
actual market conditions.

Statistical Methods:

Statistical methods are complex set of methods of demand forecasting. These methods are
used to forecast demand in the long term. In this method, demand is forecasted on the basis of
historical data and cross-sectional data.
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Trend Projection Method:

Trend projection or least square method is the classical method of business forecasting. In this
method, a large amount of reliable data is required for forecasting demand. In addition, this
method assumes that the factors, such as sales and demand, responsible for past trends would
remain the same in future.

Barometric Method:

In barometric method, demand is predicted on the basis of past events or key variables
occurring in the present. This method is also used to predict various economic indicators, such
as saving, investment, and income. This technique helps in determining the general trend of
business activities.

Econometric Methods:

Econometric methods combine statistical tools with economic theories for forecasting. The
forecasts made by this method are very reliable than any other method. An econometric model
consists of two types of methods namely, regression model and simultaneous equations model.

Time Series Analysis:

Refers to the analysis of a series of observations over a period of equally spaced time intervals.
For example analyzing the growth of a company from its incorporation to the present situation.
Time series analysis is applicable in various fields, such as public sector, economics, and
research.

Exponential Smoothing:

Exponential smoothing is a method for forecasting trends in unit sales, unit costs, wage
expenses, and so on. The technique identifies historical patterns of trend or seasonality in the
data and then extrapolates these patterns forward into the forecast period. Its accuracy
depends on the degree to which established patterns of change are apparent and constant over
time.

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Unit No.4

Government in Market Economy:

The classical economists like Adam Smith, J.S. Say and other advocated the doctrine of laissez
faire which means non- intervention of the government in economic matters. Adam Smith
introduced the concept of the invisible hand, which refers to the free functioning of the price
(market) system in the absence of government intervention.

And, in the 19th century, the western capitalist economics achieved spectacular growth by
following the policy of laissez faire. In a modern economy like our own, the government has to
perform various roles mainly to correct the flaws (defects) of the market mechanism. The
military, policy, most schools and colleges, health centres and hospitals and highway and bridge
construction are all government activities, research and space exploration require government
funding.
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Four Main Functions of Government in a Market Economy:

1. Efficiency:

First, the government should attempt to correct market failures like monopoly and excessive
pollution to ensure efficient function-ing of the economic system. Externalities (or social costs)
occur when firms or people impose costs or benefits on others outside the marketplace.

2. Infrastructure:

Secondly, the government should provide an inte-grated infrastructure. Infrastructure (or social
overhead capital) refers to those activities that enhance, directly or indirectly, output levels or
effi-ciency in production.

3. Equity:

Markets do not necessarily produce a distribution of income that is regarded as socially fair or
equitable. As market economy may produce unacceptably high levels of inequality of income
and weather. Government programmes to promote equity use taxes and spending to
redistribute income toward particular groups.

4. Economic Growth or Stability:

Fourthly, governments rely upon taxes, expenditures and monetary regulation to foster
macroeconomic growth and stability to reduce unemployment and inflation while encouraging
eco-nomic growth.

Optimal Allocation of Resources:

The concept is that every person in the community with any social background will have the
equal opportunity to enjoy the resources.

Theory of allocation:

The analysis of the behaviour of firms and households is to some extent symmetrical: all
economic agents are conceived of as ordering a series of attainable positions in terms of an
entity they are trying to maximize. A firm aims to maximize its use of input combinations, while
a household attempts to maximize product combinations. From the maximizing point of view,
some combinations are better than others, and the best combination is called the “optimal” or
“efficient” combination. As a rule, the optimal allocation equalizes the returns of the marginal
(or last) unit to be transferred between all the possible uses. In the theory of the firm, an
optimum allocation of outlays among the factors is the same for all factors; the “law of
eventually diminishing marginal utility,” a property of a wide range of utility functions, ensures
that such an optimum exists.

Benefit Cost Methodology and Criteria:

Cost–benefit analysis (CBA), sometimes called benefit costs analysis (BCA), is a systematic
approach to estimating the strengths and weaknesses of alternatives. It is used to determine
options that provide the best approach to achieve benefits while preserving savings. It may be
used to compare potential (or completed) courses of actions, or to estimate (or evaluate) the
value against costs of a single decision, project, or policy. Common areas of application include
commercial transactions, functional business decisions, policy decisions (especially government
policy), or project investments.
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Theory of Cost Benefit Analysis:

Cost–benefit analysis is often used by organizations to appraise the desirability of a given

policy. It is an analysis of the expected balance of benefits and costs, including an account of
any alternatives and of the status quo. CBA helps predict whether the benefits of a policy
outweigh its costs, and by how much, relative to other alternatives. This allows for ranking of
alternate policies in terms of cost–benefit ratio. Generally, accurate cost–benefit analysis
identifies choices that increase welfare from a utilitarian perspective. Assuming an accurate
CBA, changing the status quo by implementing the alternative with the lowest cost–benefit
ratio can improve Pareto efficiency.

Process

The following is a list of steps that compose a generic cost–benefit analysis.

 Define the goals and objectives of the action.

 List alternative actions.
 List stakeholders.
 Select measurement(s) and measure all cost and benefit elements.
 Predict outcome of costs and benefits over the relevant time period.
 Convert all costs and benefits into a common currency.
 Apply discount rate.
 Calculate the net present value of actions under consideration.
 Perform sensitivity analysis.
 Adopt the recommended course of action.

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Unit No.5

Intro to Production Theory:

In economics, production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also how
much of raw material ie., fixed capital and labor it employs and how much it will use. It defines
the relationships between the prices of the commodities and productive factors on one hand
and the quantities of these commodities and productive factors that are produced on the other
hand.

Concept of Production Theory:

Production is a process of combining various inputs to produce an output for consumption. It is

the act of creating output in the form of a commodity or a service which contributes to the
utility of individuals.

In other words, it is a process in which the inputs are converted into outputs.

Function:

The Production function signifies a technical relationship between the physical inputs and
physical outputs of the firm, for a given state of the technology.

Q = f (a, b, c, . . . . . . z)

Where a,b,c ....z are various inputs such as land, labor ,capital etc. Q is the level of the output
for a firm.
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If labor (L) and capital (K) are only the input factors, the production function reduces to −

Q = f(L, K)

Production Function describes the technological relationship between inputs and outputs. It is a
tool that analysis the qualitative input – output relationship and also represents the technology
of a firm or the economy as a whole.

Production Analysis:

Production analysis basically is concerned with the analysis in which the resources such as land,
labor, and capital are employed to produce a firm’s final product. To produce these goods the
basic inputs are classified into two divisions −

Variable Inputs:

Inputs those change or are variable in the short run or long run are variable inputs.

Fixed Inputs:

Inputs that remain constant in the short term are fixed inputs.

Optimal Combination of Inputs:

In the long run, all factors of production can be varied. The profit maximization firm will choose
the least cost combination of factors to produce at any given level of output. The least cost
combination or the optimum factor combination refers to the combination of factors with
which a firm can produce a specific quantity of output at the lowest possible cost.

Isoquants:

Isoquants are a geometric representation of the production function. The same level of output
can be produced by various combinations of factor inputs. The locus of all possible
combinations is called the ‘Isoquant’.

Characteristics of Isoquant:

An isoquant slopes downward to the right.

An isoquant is convex to origin.

An isoquant is smooth and continuous.

Two isoquants do not intersect.

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Unit No.6

Cost Function:

Cost function is defined as the relationship between the cost of the product and the output.
Following is the formula for the same −

C = F [Q]

Cost function is divided into namely two types −

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Short Run Cost

Short run cost is an analysis in which few factors are constant which won’t change during the
period of analysis. The output can be changed ie., increased or decreased in the short run by
changing the variable factors.

Following are the basic three types of short run cost –

Short Run fixed Cost, Variable Cost, Short Run Total Cost

Long Run Cost

Long-run cost is variable and a firm adjusts all its inputs to make sure that its cost of production
is as low as possible.

Long run cost = Long run variable cost

In the long run, firms don’t have the liberty to reach equilibrium between supply and demand
by altering the levels of production. They can only expand or reduce the production capacity as
per the profits. In the long run, a firm can choose any amount of fixed costs it wants to make
short run decisions.

What is the Learning Curve

A learning curve is a concept that graphically depicts the relationship between the cost and
output over a defined period of time, normally to represent the repetitive task of an employee
or worker. The learning curve was first described by psychologist Hermann Ebbinghaus in 1885
and is used as a way to measure production efficiency and to forecast costs.

The learning curve also is referred to as the experience curve, the cost curve, the efficiency
curve or the productivity curve. This is because the learning curve provides measurement and
insight into all the above aspects of a company.

Learning curve is downward sloping in the beginning with a flat slope toward the end, with the
cost per unit depicted on the Y-axis and total output on the X-axis. As learning increases, it
decreases the cost per unit of output initially before flattening out, as it becomes harder to
increase the efficiencies gained through learning.

Benefits of Learning Curve:

The learning curve does a good job of depicting the cost per unit of output over time.
Companies know how much an employee earns per hour and can derive the cost of producing a
single unit of output based on the amount of hours needed. A well-placed employee who is set
up for success should decrease the company's costs per unit of output over time. Businesses
can use the learning curve to conduct production planning, cost forecasting and logistic
schedules.

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Unit No.7

Market Structure:

A market is the area where buyers and sellers contact each other and exchange goods and
services. Market structure is said to be the characteristics of the market. Market structures are
basically the number of firms in the market that produce identical goods and services. Market
structure influences the behavior of firms to a great extent. The market structure affects the
supply of different commodities in the market.
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Perfect Competition

Perfect competition is a situation prevailing in a market in which buyers and sellers are so
numerous and well informed that all elements of monopoly are absent and the market price of
a commodity is beyond the control of individual buyers and sellers

With many firms and a homogeneous product under perfect competition no individual firm is in
a position to influence the price of the product that means price elasticity of demand for a
single firm will be infinite.

Monopolistic Competition

Monopolistic competition is a form of market structure in which a large number of independent

firms are supplying products that are slightly differentiated from the point of view of buyers.
Thus, the products of the competing firms are close but not perfect substitutes because buyers
do not regard them as identical. This situation arises when the same commodity is being sold
under different brand names, each brand being slightly different from the others.

Monopoly

Monopoly is said to exist when one firm is the sole producer or seller of a product which has no
close substitutes. According to this definition, there must be a single producer or seller of a
product. If there are many producers producing a product, either perfect competition or
monopolistic competition will prevail depending upon whether the product is homogeneous or
differentiated.

On the other hand, when there are few producers, oligopoly is said to exist. A second condition
which is essential for a firm to be called monopolist is that no close substitutes for the product
of that firm should be available.

Oligopoly

In an oligopolistic market there are small number of firms so that sellers are conscious of their
interdependence. The competition is not perfect, yet the rivalry among firms is high. Given that
there are large number of possible reactions of competitors, the behavior of firms may assume
various forms. Thus there are various models of oligopolistic behavior, each based on different
reactions patterns of rivals.

Oligopoly is a situation in which only a few firms are competing in the market for a particular
commodity. The distinguishing characteristics of oligopoly are such that neither the theory of
monopolistic competition nor the theory of monopoly can explain the behavior of an
oligopolistic firm.

Game Theory:

In game theory, a player's strategy is any of the options which he or she can choose in a setting
where the outcome depends not only on their own actions but on the actions of others. A
player's strategy will determine the action which the player will take at any stage of the game.

The strategy concept is sometimes (wrongly) confused with that of a move. A move is an action
taken by a player at some point during the play of a game. A strategy on the other hand is a
complete algorithm for playing the game, telling a player what to do for every possible situation
throughout the game.
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Pure and mixed strategies:

Pure Strategy:

A pure strategy provides a complete definition of how a player will play a game. In particular, it
determines the move a player will make for any situation he or she could face.

Mixed Strategy:

A mixed strategy is an assignment of a probability to each pure strategy. This allows for a player
to randomly select a pure strategy.

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Unit No.8

Pricing:

Pricing is the process of determining what a company will receive in exchange for its product or
service. A business can use a variety of pricing strategies when selling a product or service. The
price can be set to maximize profitability for each unit sold or from the market overall. It can be
used to defend an existing market from new entrants, to increase market share within a market
or to enter a new market.

Pricing a New Product:

The price fixed for the new product must have completed the advanced research and
development, satisfy public criteria such as consumer safety and earn good profits. In pricing a
new product, below mentioned two types of pricing can be selected −

Skimming Price

Skimming price is known as short period device for pricing. Here, companies tend to charge
higher price in initial stages. Initial high helps to “Skim the Cream” of the market as the demand
for new product is likely to be less price elastic in the early stages.

Penetration Price

Penetration price is also referred as stay out price policy since it prevents competition to a
great extent. In penetration pricing lowest price for the new product is charged. This helps in
prompt sales and keeping the competitors away from the market.

Multiple Products

As the name indicates multiple products signifies production of more than one product. The
traditional theory of price determination assumes that a firm produces a single homogenous
product. But firms in reality usually produce more than one product and then there exists
interrelationships between those products.

Following are the pricing methods followed −

Full Cost Pricing Method:

Full cost plus pricing is a price-setting method under which you add together the direct material
cost, direct labor cost, selling and administrative cost, and overhead costs for a product and add
to it a markup percentage in order to derive the price of the product. The pricing formula is −

Pricing formula = Total production costs − Selling and administration costs − Markup
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Number of units expected to sell

This method is most commonly used in situations where products and services are provided
based on the specific requirements of the customer.

Marginal Cost Pricing Method:

The practice of setting the price of a product to equal the extra cost of producing an extra unit
of output is called marginal pricing in economics. By this policy, a producer charges for each
product unit sold, only the addition to total cost resulting from materials and direct labor.
Businesses often set prices close to marginal cost during periods of poor sales.

Price discrimination:

Price discrimination is a microeconomic pricing strategy where identical or largely similar goods
or services are transacted at different prices by the same provider in different markets. Price
discrimination is distinguished from product differentiation by the more substantial difference
in production cost for the differently priced products involved in the latter strategy. Price
differentiation essentially relies on the variation in the customers' willingness to pay and in the
elasticity of their demand.

The term differential pricing is also used to describe the practice of charging different prices to
different buyers for the same quality and quantity of a product, but it can also refer to a
combination of price differentiation and product differentiation.

Transfer Pricing:

Transfer Pricing relates to international transactions performed between related parties and
covers all sorts of transactions.

The most common being distributorship, R&D, marketing, manufacturing, loans, management
fees, and IP licensing.

All intercompany transactions must be regulated in accordance with applicable law and comply
with the "arm's length" principle which requires holding an updated transfer pricing study and
an intercompany agreement based upon the study.

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Unit No.9

What Is Risk Analysis?

Risk Analysis is a process that helps you identify and manage potential problems that could
undermine key business initiatives or projects.

To carry out a Risk Analysis, you must first identify the possible threats that you face, and then
estimate the likelihood that these threats will materialize.

How to Use Risk Analysis:

1. Identify Threats

The first step in Risk Analysis is to identify the existing and possible threats that you might face.
These can come from many different sources.
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2. Estimate Risk

Once you've identified the threats you're facing, you need to calculate out both the likelihood
of these threats being realized, and their possible impact.

One way of doing this is to make your best estimate of the probability of the event occurring,
and then to multiply this by the amount it will cost you to set things right if it happens. This
gives you a value for the risk:

Risk Value = Probability of Event x Cost of Event

RISK AND UNCERTAINTY IN MANAGERIAL DECISION MAKING:

Managerial decisions are made under conditions of certainty, risk, or uncertainty.

Certainty refers to the situation where there is only one possible outcome to a de-cision and
this outcome is known precisely.

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 esti-mated. Thus, risk requires that the
decision maker knows all the possible out-comes of the decision and have some idea of the
probability of each outcome's occurrence.

In the analysis of managerial decision making involving risk, we will use such concepts as
strategy, states of nature, and payoff matrix.

A strategy refers to one of several alternative courses of action that a decision maker can take
to achieve a goal.

States of nature refers to conditions in the future that will have a significant effect on the
degree of success or failure of any strategy, but over which the decision maker has little or no
control.

A payoff matrix is a table that shows the possible outcomes or results of strategy under each
state of nature.

MEASURING RISK WITH PROBABILITY DISTRIBUTIONS

Risk is the situation where there is more than one possible outcome to a decision and the
probability of each possible outcome is known or can be estimated.

Probability Distributions

The concept of probability distributions is essential in evaluating and com-paring investment

projects. In general, the outcome or profit of, an investment project is highest when the
economy is booming and smallest when the economy is in a recession. If we multiply each
possible outcome or profit of an investment by its probability of occurrence and add these
products, we get the expected value or profit of the project. That is,

Expected profit =

where tt, is the profit level associated with outcome i, P, is the probability that outcome / will
occur, and i' = 1 to n refers to the number of possible outcomes or states of nature.

Utility Theory:

Utility theory provides a methodological framework for the evaluation of alternative choices
made by individuals, firms and organizations. Utility refers to the satisfaction that each choice
provides to the decision maker. Thus, utility theory assumes that any decision is made on the
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basis of the utility maximization principle, according to which the best choice is the one that
provides the highest utility (satisfaction) to the decision maker.

In economics and finance, risk aversion is the behavior of humans (especially consumers and
investors), who, when exposed to uncertainty, attempt to lower that uncertainty. It is the
hesitation of a person to agree to a situation with an unknown payoff rather than another
situation with a more predictable payoff but possibly lower expected payoff.