UNIT-I

INTRODUCTION TO MANAGERIAL ECONOMICS

Introduction:

Managerial economics generally refers to the integration of economic theory with business practice.
Economics provides tools managerial economics applies these tools to the management of business.
In simple terms, managerial economics means the application of economic theory to the problem of
management. Managerial economics may be viewed as economics applied to problem solving at the
level of the firm.

It enables the business executive to assume and analyse things. Every firm tries to get satisfactory
profit even though economics emphasizes maximizing of profit. Hence, it becomes necessary to
redesign economic ideas to the practical world. This function is being done by managerial
economics.

Definition of Managerial Economics:

According to E.F. Brigham and J. L. Pappar, Managerial Economics is “the application of
economic theory and methodology to business administration practice.”

Milton H. Spencer and Lonis Siegelman define Managerial Economics as “the integration of
economic theory with business practice for the purpose of facilitating decision making and forward
planning by management.”

DEFINITION OF ECONOMICS:

According to Adam Smith, the Father of Economics, defined economics as the study of
nature and uses of national wealth’.

Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes
“Economics is a study of man’s actions in the ordinary business of life: it enquires how he gets his
income and how he uses it”.

Thus, it is one side, a study of wealth and on the other, and more important side, it is the
study of man. The activity of earning money and spending this money to satisfy our needs and wants
is called economic activity.

The salient features of economics according to Prof Robbins are as follows:

1. Unlimited wants: We have unlimited numbers of wants or ends and it is difficult to satisfy
all these.
2. Scarce resources: we have limited or scarce resources. The resources are said to be scarce
when they are limited in supply with relation to total demand. Economic problems arise only
because the resources we have are scarce.
3. Alternative uses: scarce resources can be put to alternative uses. In other words, a particular
commodity or goods can be put to different alternative uses.

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 4. Choice: Of all the above alternatives, which one do I choose? How do I behave in satisfying
my unlimited wants the scarce resources?

Types of Economics:
Economics is of two types
1. Micro economics
2. Macro economics

1. Micro economics:
 The study of an individual consumer or a firm is called microeconomics (also called the
Theory of Firm).
 Microeconomics deals with behaviour and problems of single individual and of micro
organization.
 It is concerned with the application of the concepts such as price theory, Law of Demand and
theories of market structure and so on.

2. Macro economics:
 The study of ‘aggregate’ or total level of economic activity in a country is called
macroeconomics.
 It deals with the price level in general, instead of studying the prices of individual
commodities.
 It discusses aggregate consumption, aggregate investment, price level, and payment, theories
of employment, and so on.

Definitions of Managerial Economics:

According to M. H. Spencer and Louis Siegelman, “Managerial Economics is the
integration of economic theory with business practice for the purpose of facilitating decision making
and forward planning by management”.

Difference between economics and management:

Economics Managerial Economics

 Dealing with micro and macro  Dealing only micro aspects

aspects.
 Both positive science( deals what is)  It is only a normative science ( deals
and normative science ( deals with with what ought to be)
what ought to be)

 Deals with theoretical aspects.  Deals with practical aspects.

 Study both firm and invidual.  Study the problem of a firm.

 It has wide scope.  It has narrow scope.

Management:

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  Management is the science and art of getting things done through people in formally
organized groups.
 Management includes a number of functions: Planning, organizing, staffing, directing, and
controlling.
 The manager while directing the efforts of his staff communicates to them the goals,
objectives, policies, and procedures; coordinates their efforts; motivates them to sustain their
enthusiasm; and leads them to achieve the corporate goals.

Nature of Managerial Economics:

 Close to microeconomics: Managerial economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.

 Operates against the backdrop of macroeconomics: The managerial economist has to be

aware of the limits set by the macroeconomics conditions such as government industrial
policy, inflation and so on.

 Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives
of the firm, it suggests the course of action from the available alternatives for optimal solution.

 Offers scope to evaluate each alternative: Managerial economics provides an opportunity to

evaluate each alternative in terms of its costs and revenue. The managerial economist can
decide which is the best alternative to maximize the profits for the firm.

 Normative statements: A normative statement usually includes or implies the words ought or
should. Statements are based on value judgements and express views of what is good or bad,
right or wrong.

 Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from
different subjects such as economics, management, mathematics, statistics, accountancy,
psychology, organizational behaviour, sociology and etc.

Scope of Managerial Economics:

The scope of managerial economics refers to its area of study.

concepts &
techniques of applied to
Managerial optimum solutions
Managerial decision areas
Economics

The scope of managerial economics covers two areas of decision making

a. Operational or Internal issues

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 b. Environmental or External issues

a. Operational issues:
 Operational issues refer to those functions which are within the business organization and
they are under the control of the management. Those are:

1. Resource Allocation:
Managerial economics helps the managers to allocate scarce or available resources to various
alternative uses to optimise costs and revenues( maximising revenues by minimising cost) for the
firm.

2. Price – output decision:

 Managerial economics is mostly concerned with pricing decisions.
 A business firm has to decide about what type of pricing method or strategy it has to follow.

3. Demand Analysis and Forecasting:

A firm is an economic organisation which transforms inputs into output that is to be sold in a
market. Accurate estimation of demand, by analysing the forces acting on demand of the product
produced by the firm, forms the vital issue in taking effective decision at the firm level.

A major part of managerial decision making depends on accurate estimates of demand. When
demand is estimated, the manager does not stop at the stage of assessing the current demand but
estimates future demand as well. This is what is meant by demand forecasting.

This forecast can also serve as a guide to management for maintaining or strengthening
market position and enlarging profit. Demand analysis helps in identifying the various factors
influencing the demand for a firm’s product and thus provides guidelines to manipulate demand. The
main topics covered are: Demand Determinants, Demand Distinctions and Demand Forecasting.

4. Cost and Production Analysis:

Cost analysis is yet another function of managerial economics. In decision making, cost
estimates are very essential. The factors causing variation in costs must be recognised and allowed
for if management is to arrive at cost estimates which are significant for planning purposes.

The determinants of estimating costs, the relationship between cost and output, the forecast
of cost and profit are very vital to a firm. An element of cost uncertainty exists because all the factors
determining costs are not always known or controllable. Managerial economics touches these aspects
of cost analysis as an effective knowledge and the application of which is corner stone for the
success of a firm.

Production analysis frequently proceeds in physical terms. Inputs play a vital role in the
economics of production. The factors of production otherwise called inputs, may be combined in a
particular way to yield the maximum output.

5. Inventory Management:
An inventory refers to a stock of raw materials which a firm keeps. Now the problem is how
much of the inventory is the ideal stock. If it is high, capital is unproductively tied up. If the level of
inventory is low, production will be affected.

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 6. Pricing Decision, Policies and Practices:
Pricing is very important area of managerial economics. The control functions of an
enterprise are not only productions but pricing as well. When pricing a commodity, the cost of
production has to be taken into account. Business decisions are greatly influenced by pervading
market structure and the structure of markets that has been evolved by the nature of competition
existing in the market.

7. Profit Management:
A business firm is an organisation designed to make profits. Profits are acid test of the
individual firm’s performance. In appraising a company, we must first understand how profit arises.
The concept of profit maximisation is very useful in selecting the alternatives in making a decision at
the firm level.

8. Capital Management:
Planning and control of capital expenditures is the basic executive function. The managerial
problem of planning and control of capital is examined from an economic stand point. The capital
budgeting process takes different forms in different industries.

B. Environmental or External Issues:

An environmental issue in managerial economics refers to the general business environment
in which the firm operates. They refer to general economic, social and political atmosphere within
which the firm operates.
a. The type of economic system in the country.
b. The general trends in production, employment, income, prices, saving and investment.
c. Trends in the working of financial institutions like banks, financial corporations, insurance
companies
d. Trends in foreign trade;
e. Trends in labour and capital markets;
f. Government policies.

Managerial economics and its relation with other subjects:

Managerial economics is closely linked with many other disciplines such as economics,
accounting, mathematics, statistics, operations research, psychology, and organizational behaviour.
Let us see these linkages in detail:

Relationship with economics:

 The concepts of managerial economics are basically economic concepts.
 If economics deals with theoretical concepts, managerial economics is the application of
these concepts in the real life.
 Economics and managerial economics, both are concerned with the problems of scarcity and
resource allocation.
Relation with Operations Research:

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  Operation research helps managerial economists in the field of product development, material
management, and inventory control, quality control, marketing and demand analysis.
 If managerial economics focuses on ‘problems of decision making”, operations research
focus on finding solutions for many a managerial problem. ‘model building’ is one area of
common exercise.
 The operations research models such as linear programming, queuing, transportation,
optimisation techniques and so on, are extensively used in solving the managerial problems.

Relation with accounting:

 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.
 The accountant provides accounting information relating to cost, revenues, receivables,
payables, profits/losses etc.
 The managerial economist depends up on accounting data for decision making and forward
planning.

Relation with mathematics:

 Managerial economist is concerned with estimating the relevant economic factors for
decision making and forward planning.
 In this process, he extensively makes use of the tools and techniques of mathematics such as
algebra, calculus, exponentials, vectors, input-out tables and such other.

Relation with Statistics:

 statistical tools are used in collecting data and analyzing them to help in the decision making
process.
 Statistics deals with different techniques useful to analyse the cause and effect relationships
in a given variable.
 The theory of probability is very useful in problems involving uncertainty.
 The statistical techniques such as averages, measures of dispersion, correlation, regression,
time series, interpolations, probability, and so on.

Relation with psychology:

 Consumer psychology is the basis on which managerial economist acts up on.
 How the customer reacts to a given change in price or supply and its consequential effect on
demand/profits.
 Psychology contributes towards understanding the behavioural, attitudes of customers.

Role of Managerial Economist:

A managerial economist helps the management by using his analytical skills and highly
developed techniques in solving complex issues of successful decision-making and future advanced
planning. The role of managerial economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analysis it’s significance to the specific
firm he is working in.

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 2. He has to consistently examine the probabilities of transforming an ever-changing economic
environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a firm such
as changes in price, investment plans, type of goods /services to be produced, inputs to be
used, techniques of production to be employed, expansion/ contraction of firm, allocation of
capital, location of new plants, quantity of output to be produced, replacement of plant
equipment, sales forecasting, inventory forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic indicators
such as national income, population, business cycles, and their possible effect on the firm’s
functioning.
7. He is also involved in advicing the management on public relations, foreign exchange, and
trade. He guides the firm on the likely impact of changes in monetary and fiscal policy on the
firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect economic
data and examine all crucial information about the environment in which the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed research on
industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an elaborate
statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates, competitor’s
price and product, etc. They give their valuable advice to government authorities as well.
13. At times, a managerial economist has to prepare speeches for top management.

Basic Economic Tools and Principles:

Economic theory offers a variety of concepts and analytical tools which can be of considerable
assistance to the managers in his decision making practice. These tools are helpful for managers in
solving their business related problems. These tools are taken as guide in making decision.

Following are the basic economic tools for decision making:

1. Opportunity cost principle

2. Incremental principle
3. Principle of Time Perspective
4. Discounting Principle
5. Equi – marginal Principle

1) Opportunity cost principle:

By the opportunity cost of a decision is meant the sacrifice of alternatives required by that
decision.

For e.g.
a) The opportunity cost of the funds employed in one’s own business is the interest that could be
earned on those funds if they have been employed in other ventures.

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b) The opportunity cost of using a machine to produce one product is the earnings forgone which
would have been possible from other products.

c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest,
which would have been earned had the money been kept as fixed deposit in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no
sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant
costs.

2) Incremental principle:

It is related to the marginal cost and marginal revenues, for economic theory. Incremental
concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing
the changes in total cost and total revenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are

1. Incremental cost
2. Incremental Revenue
The incremental principle may be stated as under:

“A decision is obviously a profitable one if –

 it increases revenue more than costs

 it decreases some costs to a greater extent than it increases others
 it increases some revenues more than it decreases others and
 it reduces cost more than revenues”

3) Principle of Time Perspective:

Managerial economists are also concerned with the short run and the long run effects of
decisions on revenues as well as costs. The very important problem in decision making is to maintain
the right balance between the long run and short run considerations.

For example;

Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to
management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot
but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the
contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot)

Analysis:

From the above example the following long run repercussion of the order is to be taken into account:

1) If the management commits itself with too much of business at lower price or with a small
contribution it will not have sufficient capacity to take up business with higher contribution.

2) If the other customers come to know about this low price, they may demand a similar low price.
Such customers may complain of being treated unfairly and feel discriminated against.

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In the above example it is therefore important to give due consideration to the time perspectives. “a
decision should take into account both the short run and long run effects on revenues and costs and
maintain the right balance between long run and short run perspective”.

4) Discounting Principle:

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a
rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or
Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two reasons-

i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity
is not availed of

ii) Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to earn
interest say as 8% so that one year after Rs.100/- will become 108

5) Equi – marginal Principle:

This principle deals with the allocation of an available resource among the alternative
activities. According to this principle, an input should be so allocated that the value added by the last
unit is the same in all cases. This generalization is called the equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which
need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more
labor but only at the cost of other activities.

Risk and Uncertainty:

Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is
uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle,
structure of the economy and government policies.

This means that the management must assume the risk of making decisions for their institution in
uncertain and unknown economic conditions in the future. Firms may be uncertain about production,
market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not
known immediately for certain.

Economic theory generally assumes that the firm has perfect knowledge of its costs and demand
relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty
arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost
and revenue data of their firms with reasonable accuracy.

Also dynamic changes are external to the firm, they are beyond the control of the firm. 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. But products must attempt to predict the
future cost and revenue data of their firms and determine the output and price policies.

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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
expectations about cost, revenue and the environment. The probabilities of future events are
influenced by the time horizon, the risk attitude and the rate of change of the environment.

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