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© Oxford
Managerial Economics, Second Edition University Press. All rights reserved.
Contents
Preface to the Second Edition
Preface to the First Edition
PART ONE
The Foundation
1. Foundations of
Managerial Economics
Introduction 3
1.1 What is Economics? 4
1.2 Definition and Scope of
Managerial Economics 6
1.3 Typical Decisions Handled
by Managerial Economics 7
1.4 Opportunity Costs 9
1.5 Positioning Managerial
Economics in the Big Picture 10
1.6 The Theory of the Firm
and the Role of Profits 11
1.7 Why do Economic
Profits Exist? 13
1.8 The Invisible Hand 13
1.9 Microeconomic Problems
in Managerial Economics 14
1.10 Supply–demand Analysis 15
1.11 Total, Average, and
Marginal Magnitudes 17
1.12 The Concept of Margin 21
PART TWO
The Household and the Firm
2. Demand
Introduction 27
2.1 Meaning of Demand 27
2.2 Law of Demand and
Exceptions to the Law 28
© Oxford University Press. All rights reserved.
v Why is the Demand Curve
vii Negatively Sloped? 29
Exceptions to the Law of Demand 30
2.3 Shifts in Demand 31
2.4 Market Demand and
Its Interpretation 32
2.5 From Individual Demand
3
to Market Demand 32
2.6 Slope and Elasticities 34
2.7 Price Elasticity and
Total Expenditure 39
Price Elasticity: Some Applications
and Solved Problems 41
Determinants of Price Elasticity
of Demand 41
Price Elasticity—Special Cases 43
Price Elasticity along a
Linear Demand Curve 43
Price Elasticity, Marginal Revenue,
and Average Revenue 45
2.8 Income Elasticity of Demand 46
2.9 Cross-price Elasticity
of Demand 49
Case Study 1 54
Case Study 2 54
Case Study 3 55
3. Household as a Consumer: 56
Behind the Demand Curve
Introduction 56
3.1 The Decision-making
Process of the Consumer 57
Assumption of Completeness 58
27 Assumption of Transitivity 58
Assumption of Non-satiation 58
3.2 Utility—Concept and
Measurement 58
Cardinal and Ordinal Utility 59
xii Contents
3.3 Optimization—
The Cardinal Approach 60
3.4 Deriving the Demand Curve—
The Cardinal Approach 65
3.5 Optimization—
The Ordinal Approach 66
3.6 Indifference Curves 66
3.7 Properties of
Indifference Curves 67
3.8 Other Types of
Indifference Curves 70
3.9 Budget Constraints 72
3.10 The Consumer’s Equilibrium
and Optimal Combination 74
Consumer Equilibrium
Expressed in Utility 76
3.11 Changes in Equilibrium
When Prices Change 77
3.12 Deriving the Demand
Curve—The Ordinal Approach
3.13 Changes in Equilibrium
When Income Changes 81
3.14 Income and Substitution
Effects of a Price Change
and Giffen Goods 83
3.15 Exception to the Law of
Demand—The Case of
Giffen Goods 85
3.16 Applications of
Indifference Curves 86
Welfare Effects of a Direct Tax
vs an Indirect Tax 87
4. Demand Estimation
and Forecasting
Introduction 95
4.1 Demand Estimation Using
Qualitative Research Techniques
4.2 Statistical Estimation of
Demand Function 97
Step 1: Identification of Variables 98
Step 2: Collecting Historical Data 98
Step 3: Specification of the Model 98
Step 4: Simple Linear Regression Model 101
4.3 Forecasting 117
Forecasting Techniques 118
Case Study 1 133
Case Study 2 134
© Oxford University Press. All rights reserved.
5. Firm as a Producer 135
Introduction 135
5.1 Existence of Firms 135
5.2 Profits—The Motive
behind Existence 137
5.3 Determination of the
Profit-maximizing Level
of Output 139
Total Revenue 140
Total Economic Cost 141
Marginal Revenue and Marginal Cost 143
5.4 Do Firms Really
Maximize Profits? 146
Internal Control Mechanisms 148
External Control Mechanisms 150
Profit Maximization over Time 151
5.5 Goals of Non-profit Firms
and Public Sector Firms 151
78 5.6 Global Firms 152
What Characterizes an MNC? 153
What is Attractive about
being an MNC? 153
How can Firms Become MNCs? 153
Are There no Complications at all? 156
Case Study 159
6. Analysis of Production: 160
Theory and Estimation
Introduction 160
6.1 Production Decisions 160
Decisions Bringing Together Inputs
95 to Produce the Product or Output 161
Variety in the Decisions—
Short Run and Long Run 162
Production Function 164
6.2 Production Function with
96 One Variable Input (A Short-run
Production Function) 164
Production Elasticity 168
Three Stages of Production 168
Three Stages of Production
and Decision-making 169
6.3 Optimal Input Levels
with One Variable Input 169
6.4 Production Function Where
All Inputs are Variable—
Case of Two Variable Inputs 173

Properties of Isoquants 176
Relationship between Marginal
(Physical) Product and Marginal
Rate of Technical Substitution 177
Relationship between MRTS and
Elasticity of Substitution 179
Appreciation of the Isoquant Model 180
6.5 Determination of Optimal
Combination of Inputs
When All Inputs are Variable
6.6 Returns to Scale 184
Source of Returns to Scale 185
Graphical Representation of
Returns to Scale 187
6.7 Statistical Estimation of
Production Function 188
Cobb–Douglas Production Function 189
Euler’s Theorem 190
Example of Estimation of
Production Function 191
Problems of Data Specification in the
Estimation of Production Functions 192
Empirical Studies of the
Production Function 193
6.8 Isoproduct Curves and
Production Frontiers 194
Case Study 1 199
Case Study 2 200
7. Analysis and Estimation
of Costs
Introduction 202
7.1 The Economic Concept
of Cost 203
7.2 From Production Function to
Cost Function—Long-run
Total Cost 204
7.3 Relationship between Cost
and Output in the Long Run 206
7.4 Cost and Output Relationship
in the Short Run 208
7.5 Average and Marginal Cost
Curves in the Long Run 212
Sources of Economies of Scale 213
7.6 Average and Marginal
Cost Curves in the Short Run
Relationship between SRMC
and SRAVC Curves 219
© Oxford University Press. All rights reserved.
Contents xiii
7.7 Relationship between Average
Cost Curves—Long Run and
Short Run 222
Using LRAC in Decision-making 226
7.8 Statistical Estimation of Cost
Functions—Short-run Function 226
Polynomial Function 227
Logarithmic Function 228
Problems of Data Measurement
181 and Data Availability 228
Examples of Statistically Estimated
Short-run Cost Functions 230
7.9 Statistical Estimation of Cost
Functions—Long-run Function 231
Case Study 1 236
Case Study 2 237
Case Study 3 238
8. Supply 241
Introduction 241
8.1 Deriving the Supply Curve
of a Firm—Short Run 241
Marginal Output Rule 242
Shut Down Rule 242
8.2 Supply Curve of a Firm—
Long Run 245
8.3 Elasticity of Supply 246
Time Period 247
202 8.4 Individual Supply to
Market Supply—
Industry Supply Curve 247
Downward Sloping Industry
Supply Curve 248
8.5 Shifts in Supply Curves 248
PART THREE
Price and Output Decisions
in Product Markets
9. The Competitive and 255
Monopoly Model
Introduction 255
9.1 Equilibrium in Competitive
Markets—Price Takers’
217 Equilibrium 256
Characteristics of a Perfectly
Competitive Market 256
xiv Contents
9.2 Interference with Equilibrium 261
9.3 Output Decisions for a Firm in
a Perfectly Competitive Market 262
9.4 Some Uses of the
Competitive Model 264
9.5 Normative Analysis of
Perfect Competition 270
9.6 The Monopoly Model 272
9.7 Pricing and Output Decisions
in a Monopoly 274
9.8 Monopoly vs
Competitive Solution 278
9.9 Taxing a Monopolist 280
9.10 Normative Analysis
of Monopoly 281
9.11 Public Policy and
Regulation of Monopoly 282
Antitrust Policy 283
Antitrust Legislations in India 283
Patent Policy 284
9.12 Price Discrimination 285
9.13 Breakeven Analysis 289
Case Study 1 296
Case Study 2 296
Case Study 3 296
10. Monopolistic Competition
and Oligopoly
Introduction 298
10.1 Monopolistic Competition—
Assumptions and Features 299
10.2 Determination of Short-run
and Long-run Equilibrium 300
Optimal Level of Selling and
Promotional Outlays 302
10.3 Normative Analysis of
Monopolistic Competition 302
10.4 Features of Oligopoly 303
10.5 Equilibrium in Oligopoly 304
Numerical Example of
Cournot Equilibrium 306
Bertrand Model 308
Stackelberg Model 309
The Kinked Demand Model 310
Collusion 313
Price Leadership 316
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10.6 Barriers to Entry 318
Sources of Barriers to Entry 318
10.7 Some Basic Concepts of
Game Theory 319
Dominant Strategies 322
Dominated Strategies 323
Maximin Strategies 324
Pure and Mixed Strategies 325
10.8 An Entry Game 325
10.9 Games of Imperfect and
Incomplete Information 326
10.10 Sequential Games—
First-mover Advantage 329
10.11 Repeated Games 330
10.12 Finitely Repeated Games 331
Case Study 1 336
Case Study 2 337
Case Study 3 337
11. Alternative Pricing Practices 339
Introduction 339
11.1 Pricing of Multiple Products 340
Products with Interdependent Demands 340
Products Related in Production
(Joint Products) 341
Fully-distributed Costs and
298
Incremental-cost Pricing 346
An Example 346
Ramsey Pricing 347
Transfer Pricing 348
11.2 Price Discrimination 351
Numerical Example to Show that
Price Discrimination is Profitable 352
Two-part Tariff 353
Peak-load Pricing 354
Product Bundling 354
Full Cost Pricing 355
Other Pricing Practices 356
11.3 Marginalism in Practice 359
Case Study 1 362
Case Study 2 362
12. Markets for Factor Inputs 365
Introduction 365
12.1 Competitive Factor Markets 365
Demand for a Single Variable Factor 366
 Contents xv

Demand for Several Variable Factors 370 Purchasing Insurance 409

Industry Demand for Factors 372 Controlling the Operating Environment 409
Supply of Inputs to a Firm 373 Restricted Use of Firm-specific Assets 410
Market Supply of Inputs 374 13.6 Production of Depletable
Equilibrium and the Concept Resources—Intertemporal
of Economic Rent 375 Aspects 410
Economic Rent 375 The Production Decision 410
12.2 Monopsony in the Expected Market Price 411
Factor Market 377 13.7 Interest Rates and
Minimum Wage Laws 378 Their Determination 413
12.3 Factor Markets with Case Study 1 417
Monopoly Power 380 Case Study 2 418
Bilateral Monopoly 382
12.4 Land as a Factor of PART FOUR
Production 383
Rent 383
Market Failures
12.5 Capital as a Factor of 14. Economics of Information 421
Production 384
12.6 Profit 385 Introduction 421
Case Study 1 389 14.1 Asymmetric Information 422
Case Study 2 389 14.2 Signalling 423
14.3 Adverse Selection 426
13. Long-term Investment and 391 Market Responses to Adverse Selection 428
Risk Analysis Government Responses to
Introduction 391 Asymmetric Information Arising
from Hidden Characteristics 431
13.1 The Capital-budgeting Process,
Basic Framework and Stages 14.4 Hidden Actions 431
in the Process 392 Moral Hazards in the Insurance Market 432
Generation of Capital Efficiency Effects of Moral Hazards 434
Investment Projects 393 Ways of Mitigating Moral Hazards 434
Estimation of Cash Flows 393 Moral Hazards in Product Markets 438
Evaluation of Investment Projects 395 Brand Name Reputations as Hostages 439
Comparison of NPV and IRR— Guarantees and Warranties 439
Do They Give the Same Rankings? 402 Case Study 1 447
Ex-post Evaluation/Review of Projects 403 Case Study 2 447
13.2 Economic Cost-benefit
Analysis 403 15. Externalities and 449
13.3 Risk and Adjustments for Risk 405 Public Goods
13.4 Decision-making under Introduction 449
Uncertainty 407 15.1 Externalities 450
Maximin Criterion 407 Private vs Social Cost 451
Minimax Regret Criterion 407 15.2 Government Responses
13.5 Managing Risk and Uncertainty 408 to Externalities 452
Seek More Information 408 Taxes 452
Diversification 408 Regulation 453
Hedging 409 Effluent Fee 453

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xvi Contents
Transferable Emission Permits 454
Recycling 456
15.3 Market Reponses
to Externalities 457
Mergers 457
Social Conventions 457
Property Rights and
Bargaining—Coase Theorem 457
A Legal Solution 460
15.4 Public Goods 460
Efficient Provision of Public Goods 462
Public Goods and Market Failure 462
Private Preferences for Public Goods 463
Impure Public Goods 463
15.5 Public–private Partnerships 464
Definition of Public–private
Partnerships 464
Scope of Public–private Partnerships 465
Contracting Out 465
Private Financing 466
Application of Public–private
Partnerships 467
Case Study 1 469
Case Study 2 470
PART FIVE
Macroeconomic Environment
16. Macroeconomic Aggregates
Introduction 473
16.1 Aggregate Output 474
Gross Domestic Product and
Gross National Product 476
16.2 Aggregate Price Level—Price
Indices 479
Consumer Price Index 479
Wholesale Price Index 481
GDP Deflator 481
16.3 Aggregate Consumption 482
Irving Fisher’s Hypothesis 485
Life Cycle Hypothesis 485
Duesenberry’s Hypothesis 486
Random Walk Hypothesis 487
© Oxford University Press. All rights reserved.
16.4 Level of Investment 487
16.5 Inflation and Unemployment 489
16.6 Balance of Payments 494
17. Fiscal, Monetary, and 502
Exchange Rate Policies
Introduction 502
17.1 Business Cycles 502
17.2 Fiscal Policy 505
17.3 Monetary Policy 510
17.4 Exchange Rate Policies 517
Devaluation 520
Prediction of Movements in
Exchange Rates 522
Relationship between Domestic
Monetary and Fiscal Policies and
Exchange Rate Policies 523
18. The New Economy 528
Introduction 528
18.1 The New Economy—
Definition and Characteristics 528
The Internet and the World Wide Web 529
18.2 Network Industries in
the New Economy 530
18.3 Impact on Industry Structure 533
18.4 The Rise and Fall of Dot-coms 534
18.5 Fundamental Laws and
Concepts of Old Economy 535
473 18.6 Internet Service Providers
in India 537
18.7 Internet Pricing Models 538
Flat-rate Pricing 538
Usage-sensitive Pricing 538
Transaction-based Pricing 539
Priority Pricing 539
Charging on the Basis of Social Cost 539
Precedence Model 539
Smart Market Mechanism Model 539
18.8 Government and the
New Economy 540
Appendices 543
Index 584

Foundations of
Managerial Economics
OBJECTIVES
After reading this chapter, the
readers will be able to
l understand the definition
and scope of economics
l gain an insight into the
basic concepts and
analytical methods of
economics
l understand the basic
supply–demand analysis,
the working of the market
mechanism, the theory of
the firm, the theory of
consumer behaviour, and
marginal analysis
l have clarity on the scope
and definition of
managerial economics
l comprehend the
fundamental questions
that economics, in general,
and managerial economics,
in particular addresses.
l appreciate the role of
economics even in contexts
where markets fail
© Oxford University Press. All rights reserved.
C HAPTE R 1
Introduction
E conomics is a subject that ranks high on familiarity. In a survey
conducted in Japan amongst lay persons, one of the questions
asked was: ‘What would the respondent associate with the
word “high”?’ The survey results revealed that a relatively large
proportion of respondents associated the word with ‘inflation’,
an unadulterated economic term, and a much smaller portion
associated the word with the volcano, Fujiyama.
The scope of economics is also very wide. It includes micro-
economics, macroeconomics, welfare economics, development
economics, mathematical economics, and a lot more. With
‘management’ having spun off as an independent discipline in
academics, the applicability of tools of microeconomics to mana-
gerial decision-making was popularized. The subject which
focuses on the application of microeconomic tools to the special
context of managerial decision-making is called ‘managerial eco-
nomics’. This chapter will focus on the definition and scope of
managerial economics.
After defining the subject and its scope, this chapter will
elaborate on the analytical tools used in managerial economics,
borrowed from microeconomics. Managerial economics borrows
two important analytical techniques from microeconomics,
‘optimization’ and ‘determination of equilibrium’. There are also
4 Managerial Economics

Inflation is the rate of other techniques, which have been borrowed from other decision
increase in prices. sciences. This chapter will focus on these two techniques, with which a
bulk of managerial economics problems can be solved. Optimization
occurs at the micro level of decision-making, wherein the decision-maker’s
objective is to arrive at the best combination of goods to be consumed or
produced, or of inputs to be employed.
The determination of equilibrium is at a slightly higher level of
aggregation at the level of markets, and is the outcome of the interaction
of the different economic agents in the market.

1.1 What is Economics?

Economics is all pervading and makes its presence felt when various
economic agents take decisions. In each of these contexts, economics
gives us techniques, rooted in sound logic, with which the decision can
be assessed in terms of the pros and cons, the advantages and disadvan-
tages, and the benefits and costs. So much so, the head of a country once
said, ‘I want a “one-handed” economist to advise ...’ because economists’
assessment will most often say ‘on the one hand ... but on the other hand
...’ Listing out outcomes, both favourable and unfavourable, makes the
final decision a well-informed one. Buying goods through a smuggler
has its own benefits and costs. Advocating heavy tax cuts may mean less
burden on individuals, but it also means less resources available to spend
on public goods; curbing imports may protect domestic industry, but it
also cuts off avenues for exports; a wage hike announcement by a leading
steel producer may ward off potential entrants into the industry, but it may
also add to overall inflation. The decision-makers using the methodology
of economics will take a decision dictated by the need of the hour, well
aware of both the favourable and the unfavourable consequences.
The whole gamut of issues addressed by economics is traditionally
classified into the following three categories of questions:
1. What to produce?
2. How to produce?
3. How to distribute?

Three critical questions These critical questions are addressed at different levels of aggregation
addressed by the in an economic system. The subject matter which addresses these
subject matter of
economics—what to
questions at the lowest degree of aggregation, which happens to be that of
produce, how to the individual as a decision-maker is called microeconomics. Managerial
produce, and how economics borrows heavily from this. The subject matter which addresses
to distribute.
these questions at the highest level of aggregation, which happens to

© Oxford University Press. All rights reserved.

 Foundations of Managerial Economics 5

be that of the decision-maker being the ‘economy’ itself, is called

macroeconomics.
These questions are difficult to answer because of scarcity of resources,
which is a fundamental characteristic of the resource base. Therefore,
decisions regarding utilization of resources that are scarce have to be
taken carefully, and economics provides the methodology to answer these
fundamental questions.
How does economics make such comprehensive assessments at the
micro level? Economics makes a simplifying assumption—that of a
rational behaviour amongst individuals—that individuals as both con-
sumers and producers seek to maximize satisfaction and profits, respec-
tively. With this rational behaviour, individuals interact and negotiate,
and arrive at the best possible solution through a very powerful mecha-
nism called the market. The solution is arrived at through the interaction
of two prominent forces in the market, demand and supply. Let us take a
real situation. You, along with 10 others from your class, decide to buy
calculators. You have in your mind a certain value attached to it and are
willing to buy so long as the price that you have to pay is less than this
value. The sellers of calculators also have in their mind a certain value
attached to the calculators and are willing to sell only when the price is
above this value. These two forces of demand and supply meet, interact,
and negotiate in a market, which enables the buyers and sellers to arrive
at a situation wherein both are able to achieve their goals. An economy
that encourages the free working of these forces in a ‘market’ and relies
on solutions arrived by the market is a ‘free market’ economy.
Later in this chapter, the reader will be exposed to a more detailed
discussion on the analytical tool of the supply–demand analysis, which is
used extensively in managerial economics.
Economics examines in detail the behaviour of individual decision-
making units, which constitute the forces of demand and supply. Since
consumers constitute the demand side of the market, economics analyses
the behaviour of the consumer (dealt with in detail in Chapters 2 and 3);
and since the producer (the firm) constitutes the supply side of the market,
the behaviour of the firms as producers is also analysed in economics
(dealt with in Chapters 5 and 6). A thorough understanding of these
market forces is important for a manager whose success or ‘failure’ is
measured by how well he ‘plays’ in the marketplace to maximize the
goals of the firm.
While providing solutions to the individual players in the marketplace,
the analytical approach suggested by economics is the marginal approach.
In this approach, problem situations are assessed by looking at the impact

© Oxford University Press. All rights reserved.

6 Managerial Economics

Marginal approach on cost and benefits at the margin. That is the impact on cost and ben-
involves using the efits of a unit change in the decision-making variable; for example, the
impact of a change to
impact on costs and benefits of a decision to increase or change quantity
take decisions.
produced by an additional unit. This ‘marginal approach’ is one of the
most significant contributions made by economics to decision-making.
Managerial economics is built on the concept of marginal analysis. This
is dealt with in greater detail later in this chapter.
While economics shows how the market mechanism provides solutions,
there are some market solutions that are not desirable from the society’s
point of view. Economics’ concern extends also to the society. For example,
if the outcome of the working of market forces is the emergence of one
large supplier, such as Microsoft in the computer software industry,
economics analyses its flip side—will the supplier then exploit the market;
or will the supplier become complacent about efficiency because there is
no one to compete with? Therefore, economics, quite naturally, enters
the area of regulation—directing the market forces to move along a
desirable direction so that society’s welfare is also maximized. Managers
ought to be aware of these aspects of regulation so that they do not break
these rules while ‘playing’ in the market.
There are also situations where markets fail to provide solutions. For
example, let us take the case where the government decides to build a
lighthouse. How much should the users be charged, and if charged, how
can non-payers be prevented from using the light emanating from the
lighthouse? The market will not provide solutions because users will not
reveal their preferences and the value attached to the services of the
lighthouse, because they can continue to use the light from the lighthouse
without revealing its worth to them. This effectively means that the
demand force is non-existent and so the market mechanism, which relies
on the interaction between demand and supply, fails. Once again,
economics comes to the rescue of the decision-makers in such situations.
This is dealt with in later chapters.

1.2 Definition and Scope of Managerial Economics

The decision-making problems addressed by economics include both

problems faced by individuals as consumers and producers and those
faced by the economy as a whole. This wide range of issues is classified
under two broad heads—those that deal with the individuals’ choice (the
individual as a consumer and as a producer), and those that need to be
addressed at the aggregate level of the economy as a whole. The former

© Oxford University Press. All rights reserved.

 Foundations of Managerial Economics 7

Microeconomic Macroeconomic Decision constitutes the subject matter of microeconomics,

Theory Theory Sciences while the latter constitutes the subject matter of
macroeconomics.
Managerial economics draws heavily from
Constitutes managerial economics microeconomic theory to provide tools and tech-
when applied to provide solutions niques to facilitate decision-making in the mana-
to decision-making situations faced
by managers gerial context. It also draws on other decision
sciences, such as operations research, to enable
Fig. 1.1 Definition, Scope, and Functions well-informed decision-making. Managerial eco-
of Managerial Economics nomics, unlike microeconomics, does not assume
the ‘aggregate’ picture as given. The manager can-
not afford to ignore the macroeconomic environment while taking rational
decisions for the firm.
The definition, scope, and functions of managerial economics have
been depicted in Fig. 1.1.
The contribution of managerial economics as a subject to managerial
decision-making has been best put by Joel Dean (1951), one of the earliest
authors on the subject. In the preface to his book, Managerial Economics,
he says, ‘The purpose of this book is to show how economic analysis can
be used in formulating business policies ... the big gap between the
problems of logic that intrigue economic theorists and the problems of
policy that plague practical management needs to be bridged in order to
give executives access to the practical contributions that economic
thinking can make to top-management policies ....’

1.3 Typical Decisions Handled by Managerial Economics

More often than not, young managers are asked to look into the economic
validity of an expansion or diversification plan. For example, if Barista, a
chain of coffee shops, decides to diversify into corner bookshops, the
first task is to economically justify this diversification, that is, if it is in the
interest of Barista to diversify. This requires the application of tools offered
by managerial economics. All readers are aware of the rivalry between
Pepsi and Coke in the soft drink market. The rationale of strategies
adopted by them to become the market leader can be found in managerial
economics. The movement in the price of petrol as a result of the
behaviour of the crude price set primarily by OPEC is not at all baffling
when the situation is analysed using the analytical frameworks provided
by managerial economics.
Coming across firms that have built capacity far in excess of what is
being effectively used seems apparently irrational, but the reader will

© Oxford University Press. All rights reserved.

8 Managerial Economics

realize that it is not so after gaining familiarity with managerial economics.

Firms often face problems regarding optimum resource allocation on
the shop floor. Questions, such as what the size of the production run
should be; which is the least cost combination of inputs the production
engineer needs to employ in order to minimize costs; what should the
product be priced at; should a new production process be adopted? etc.,
are addressed by managerial economics.
These typical managerial problems can, in one way or the other, be
categorized under the three fundamental economic problems addressed
by economics. These are:
1. What to produce?
2. How to produce?
3. How to distribute?
These three fundamental questions arise and need to be addressed by
The economic
decisions assume a decision-makers because of the scarcity of resources. Had resources been
high degree of plentiful, with no perceivable limits, there would not be a decision-making
criticality because they
are to be taken in the
problem. We could then have all that we wished for. For instance, you, a
context of scarce college student, would be allowed by your parents to spend any amount.
resources which have You can have all you want—ice cream, movies, music, books, weekend
alternative uses, and
in the context of getaways, and so on. As against this, put yourself in a position where you
growing wants. are given only Rs 500 per month by your parents. You will now have to
decide how much to spend on ice cream, movies, etc. It is in this latter
situation that economics comes to your help by providing tools and
techniques with which well-informed decisions can be made. The situation
is complicated by the fact that there is a constraint on the resources that
you possess and you want to get the best out of this constrained resource.
Economics helps deal with such situations where the decision-maker is
seeking a solution which maximizes in the presence of constraints, which
is called constrained maximization.
The decision-making in a situation with resource constraints could
still be easy if the uses to which the resources could be put had been
specified. For instance, if you had been told that out of Rs 500, Rs 200
should be spent on books, Rs 100 on movies, and the rest on food, the
decision-making would be less complex. However, in reality, resources
have more than one use to which they can be put; the Rs 500 can be used in
a thousand different ways. This possibility, of putting resources to more
than one use, makes decision-making difficult, and the application of
economic logic eases the process.
We could still have gotten away if, as human beings, we were a
contented lot with a well-defined fixed need set, which could be

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 Foundations of Managerial Economics 9

methodically fully satisfied. However, human beings, by nature, have a

continuously growing and constantly changing need set, which at no
point is fully satisfied, thereby only adding to the complexity. Therefore,
we have no choice but to resort to economics to provide us with tools
and techniques to enable us take the right decisions in all economic
activities, be it consumption, production, sale, or distribution.
A manager’s primary responsibility is the allocation of scarce resources
(financial, human, machines, etc.) amongst alternative uses in order to realize
the objective of profit maximization or other objectives. The link between
economic logic, tools, and techniques, and the managers’ responsibilities
could not be more obvious. Economists began focusing on and magnifying
this link, and thus, emerged the new suffix ‘managerial’ to economics
and the subject ‘managerial economics’. Thus, the suffix ‘managerial’ is
more than justified, and hence, the subject ‘managerial economics’.

1.4 Opportunity Costs

Scarcity of resources, besides imposing a constraint on the choice set,

also makes us realize that there are ‘trade offs’. Putting a resource to one
use means that you are foregoing the other uses to which you could have
put it to had you not used it in the present use. Amongst the other uses
that you could have put it to, the concern is only on the next best use. So
what you are foregoing is what you would have got had you put the
resource to its next best use. The benefits foregone by not putting it to
the next best use is therefore the cost of putting the resource to the present
use. This cost of putting the resource to the present use is nothing but
what is foregone and so, what is foregone is called the ‘opportunity cost’
of this resource being put to the present use.
In the context of consumption, this concept is used to evaluate choices.
Suppose a consumer decides to take a loan to buy a car and so has to pay
up his EMIs. He has to evaluate this decision after considering the
opportunity cost of taking the loan in terms of what he will have to forego
if he took a loan to buy a car. In the context of production, a resource is
valued at its opportunity cost, that is, at what one could have got by
putting it to the next best use or, what one is foregoing by putting it to the
present use. In the context of exchange too, this concept is used. When a
country has to decide on what it should produce and what it should trade
in, the rule is to concentrate on the production of those goods for which
it has a lower opportunity cost. The theory of comparative advantage in
the context of international trade is based on this concept. This concept
of opportunity cost is dealt with in detail in the chapter on costs.

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10 Managerial Economics

Definition: Opportunity cost is defined as what the resource would have

yielded in the next best alternative, which has to be foregone if the
resource is put to its current use.

1.5 Positioning Managerial Economics in the Big Picture

In the previous section, we saw that the answers to the three fundamental
questions are made difficult because all economies face the problem of
scarcity of resources. Economics seeks to answer these questions for
individuals at the micro level and for the nation at the macro level through
the mechanism of the market. In a market system, consumers and
producers make their own decisions and macroeconomics and managerial
economics address these issues. However, in a market system, all these
Decisions addressed by
managerial economics players take decisions simultaneously. In order to understand this
are all taken in two complexity, it is inevitable for the economists to resort to model building,
markets—factor
‘abstracting’ from the detailed reality to understand and conceptualize
market and product
market. Factor market the complex reality.
is the market where One model which fits together all these players and their activities,
factors (resources used
for production but
and helps us understand the concept of markets is the circular flow model.
owned by the This model visualizes the economy as consisting of two sectors or institu-
households) are tions—the household and the firm. The household sector owns productive
exchanged. Product
markets are those resources, such as labour, capital, and land, which can be used for pro-
where the products duction by the firms. Therefore, the household indulges in selling these
produced are
resources to the firms through a market called the factor market (Fig. 1.2).
exchanged.
The resources owned by the households are the inputs, also referred to
as factors of production, and hence, also
Product termed ‘the factor market’. With the income
Income Markets Revenue earned from the sale of factors of production,
Spent Earned the households lay a demand on goods and
Goods Goods services, which are produced by the firms and
Demanded Supplied sold to the households in a market called the
product market. The two institutions of
House households and firms get together in both the
Firms
Holds
markets and the markets throw up the fol-
Inputs Inputs lowing solutions; the quantity produced (and
Supplied Demanded sold), the cost at which it is produced (de-
pends on the price at which households sell
Income Factor
Earned Factor Costs their productive resources), and the price at
Markets (Input) which the products are sold. Microeconomics
examines these outcomes in detail and
Fig. 1.2 Circular Flow Model provides the economic logic behind these

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 Foundations of Managerial Economics 11

outcomes. This logic is used by managerial economics to provide the

decision-makers with the techniques to arrive at the desirable outcomes.
In microeconomics and managerial economics the focus is on the
aspects within these two markets of factors and products—the players,
the decision-making processes of these players, the markets, and their
dynamics.

1.6 The Theory of the Firm and the Role of Profits

Any decision is taken and evaluated in the perspective of the objective.

So is a managerial decision; it is taken and can be evaluated in the context
of its objective. The objective of the decision has to be clearly stated. For
an individual who is a consumer, the objective is to maximize satisfaction,
or what is called utility in economics. For a producer the objective is to
maximize profits or other objectives. The decision-maker as a producer
operates in an entity called the ‘firm’. The firm is an entity that brings
together resources required to produce a product. It is therefore appro-
priate at this juncture to look into the theories that would explain the
existence and working of the firm.
The theory of the firm should explain the behaviour of a firm in the
light of its objectives. Given the complexity of the working of firms,
economic and behavioural theorists have resorted to model building.
One of the earliest basic models says that the firm’s behaviour is dictated
only by its desire to maximize profits. This theory seems commonsensical
because the first objective that would come to the reader’s mind is also
profits. However, a closer look at the reality makes one realize that the
firm’s behaviour is dictated by various other considerations, such as
minimizing risk, maximizing sales, etc.
A richer version of the fundamental theory of profits is a theory that
says that the firm wishes to maximize its wealth or value. This is also the
version adopted by managerial economists and, therefore, we will
examine it in detail.
A firm’s value is defined as the present value of its expected future
cash flow. The reader will be exposed to the concept of cash flow in courses
relating to accounting/finance, but for now, we will treat cash flow as
synonymous to profits.
Present value of expected future profits
n
P τ1 Pτ2 Pτ3 P τn Pτt
= + + + ... + = ∑ t
1 + i (1 + i ) t =1 (1 + i )
2 3 n
(1 + i ) (1 + i )

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12 Managerial Economics

Economic profit is where P τ t is the profit in time period t, and i is the discount rate used to
defined as the bring the future value to the present. This method of discounting (as
difference between against compounding, which the reader may be familiar with) will be
total revenue and
total economic costs. dealt with in detail in Chapter 13.
What is profit? The reader would be able to say quite easily that profit
is the difference between total revenue and total cost. In order to maximize
profit, it is important to maximize total revenue and minimize total cost.
Therefore, every employee working for a firm has a role to play in
maximizing profits, and the behaviour of every entity in the firm can be
dictated by this objective. The shop floor producers can take measures
to increase efficiency, thereby reducing costs; the marketing managers
can take measures to increase revenue through increased sales; the
research division can develop substitutes and complements, which could
further contribute to the minimization of costs and to the maximization
of the total revenue.
Reality, again, dictates that this profit maximization cannot be an
unconstrained maximum. Many a time, managers and decision-makers
are faced with situations wherein they are stuck with some inputs, such
as a specific piece of machinery, or a contractual employment, which
they cannot tamper with even if that would lead to minimization of costs.
The decision-makers may have little flexibility in the production process
also—inputs availability may be limited. Even if economies of scale dictate
installation of large plants, limited availability of inputs may restrict the
size of the plants to be installed.
Given this fact, the techniques used to maximize profits are, therefore,
constrained optimization techniques which the reader will be exposed to
in later chapters.
Economic cost is the
Economists advocate a concept of profit called economic profit,
value of what is given wherein profit is defined as the difference between total revenue and
up or foregone total economic cost. Economic costs are what economists consider as
because of putting the
resource to its present relevant costs estimated using the principle of opportunity costs. These
use. concepts are explained in detail in the chapter on costs, suffice for now to
say that when economists speak of profit, they define total cost as inclusive
of the cost of capital and labour provided by the owner of the entity called
firm. Let us take a simple situation where Mr Chris runs a grocery store
from one room in his house (the grocery store is the firm here). He could
have taken up employment for Rs 60,000 per year, and the capital that
Firm is an entity which he has invested in the shop, if put in the bank, would fetch him a return
brings together
resources/factors for of Rs 12,000 per annum. So if Mr Chris’s venture, the grocery store, has
production of finished to be profitable, it has to earn at least Rs 72,000 per annum. Any earning
goods.
greater than Rs 72,000 is what the economists would call economic profit.

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 Foundations of Managerial Economics 13

Definition: Economic profit is defined as the difference between the total

revenue and the total economic costs. Economic cost is defined as ‘relevant’
cost. The ‘relevance’ is defined in the context of ‘run’—short run or
long run.

1.7 Why do Economic Profits Exist?

Economic profits, as defined in the previous section, arise under many

circumstances, and each of these circumstances emerges as a theory of
profit. The first situation conducive to economic profit is one where an
innovation has been made by a courageous innovator. The innovation
of the microprocessor by Intel is a classic example of the role played by
innovation in profit generation.
The second factor that explains differences in behaviour and differences
in performance, as indicated by economic profit, is the ability to take
risk, and profit is seen as a reward for risk bearing. The ability to take on
the risk of innovation, such as, the Intel chip, is to be rewarded, and that
is called economic profit.
Many a time, imperfections in the market give rise to economic profit.
A market with a single seller or a few large sellers will have greater power
and this shows up as economic profit. This is in contrast with the situation
of perfection in the market where there are a large number of sellers, so
large that no single seller has any power to influence the price in the
market. In such situations, economic profits are non-existent.
There are other theories of firms, which are discussed in detail in
Chapter 5.

1.8 The Invisible Hand

No introduction to economics in general is complete without exposing

the reader to the concept of the invisible hand. This concept is to
economics what Darwin’s principle of natural selection is to biology or
what Newton’s principle of gravitation is to astronomy.
This unifying principle is the contribution made by Adam Smith (1776)
in his book, Wealth of Nations. Adam Smith argued that even if individuals
behave selfishly and pursue their own interests, they will be indirectly
promoting the interest of the society. To quote Adam Smith:
But it is only for the sake of profit that any man employs his capital in
the support of industry; and he will always, therefore, endeavour to
employ it in the support of that industry of which the produce is likely to
be of the greatest value, or to exchange for the greatest quantity either of

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14 Managerial Economics

money or of other goods ... he is in this, as in many other cases, led by

an invisible hand to promote an end which was no part of his intention.
Nor is it always the worse for the society that it was no part of it. By
pursuing his own interests, he frequently promotes that of the society
more effectually than when he really intends to promote it.
This was conceptualized by Adam Smith more than two centuries ago
and holds good even today. Millions of transactions take place between
two ends of the world, each working with a purely selfish interest, and
yet, in the process, furthering the welfare of the nation.
Adam Smith’s conceptualization of the economy as one big market
working under some laws like the law of the invisible hand is the corner
stone of micro and managerial economics. It is from this that we derive
the concepts of the market and market economy.
Having gained familiarity with the definition and scope of managerial
economics, let us now move on to elaborate on the analytical techniques
used in managerial economics.

1.9 Microeconomic Problems in Managerial Economics

As mentioned in the introduction to this chapter, the two analytical
techniques of optimization and determination of equilibrium help bring
order in an otherwise gigantic and complex set of economic problems
by enabling the classification of the relevant economic problem as
amenable for the use of one or the other technique. When the decision-
maker wants to arrive at the best choice of goods to be produced or
consumed, it is an optimization problem. Mathematically, the process of
optimization is equivalent to finding the maximum (of a desirable variable)
or minimum (of an undesirable variable). This is what calculus deals
with. This is the reason why mathematics enters the realm of managerial
economics in a big way.
When we are interested in ascertaining the price of a good, say, onions,
in the market, from which it has little or no tendency to change, then we
are trying to arrive at an equilibrium price. This equilibrium price level
is a crucial input for fixing ceiling or floor prices in regulating markets,
and for decisions regarding entry and exit of firms.
To arrive at equilibrium solutions, the working tool used is the supply–
demand analysis, and to solve optimization problems the reader must
have an understanding of the concepts of total, average, and marginal
magnitudes and the relationship amongst these.
We will examine the supply–demand analysis in the following section,
and the total, average, and marginal magnitudes in the subsequent section.

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 Foundations of Managerial Economics 15

1.10 Supply–demand Analysis

In economics, we often resort to graphs to facilitate comprehension of

abstract phenomena, such as markets. Supply–demand analysis also can
be best understood through graphical representations. We will, therefore,
keep the graph represented in Fig. 1.3 as the reference.
In the figure, the horizontal axis represents quantities of a good per
month, per week, or per any other unit of time. The vertical axis represents
the price expressed in monetary terms, and is stated as Rs/unit of the
good. That we plot price on the Y-axis is a matter of convention (although
we will see later that price is an independent variable, and therefore,
ought to be plotted on the X-axis). The curve DD is the demand curve.
Every point on this curve shows the quantity that the consumer is willing
to demand at that price. Let us take any price, say Rs 8. The demand
curve shows the quantity Q D , which is what the consumer is willing to
buy at Rs 8. In other words, it captures the relationship between the
quantity demanded and the price, that is, what the consumer is willing to
buy at different prices. Normally, the demand curve slopes downward,
showing an inverse relationship between price and quantity. While we
will be examining the reasons for this inverse relationship in-depth later,
it is sufficient at this point to offer a commonsensical explanation to this,
that we, as consumers, tend to buy more at lower prices and less at higher
prices. The reader can relate to the discount sales offered by sellers to
attract buyers. The curve SS is the supply curve. Every point on this shows
the quantity that the seller is willing to supply at that price. For example,

Rs/Unit
(Price) SS

P=8

P′
E
P*

P ′′ DD

Quantity
QD Q S′′ QD′ Q* Q S′ QS QD′′ Q

Fig. 1.3 Basic Demand–Supply Model

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16 Managerial Economics

if the price is equal to Rs 8, the SS curve will show the quantity Q S that
the seller is willing to supply at the price, Rs 8.
In other words, the supply curve captures the relationship between
the quantity supplied and the price, that is, what the supplier is willing to
sell at different prices. Normally, the supply curve slopes upwards, show-
ing a positive relationship between the price and the quantity supplied.
While we will be examining the derivation of the supply curve in detail
later, suffice it to say that it reflects the normal tendency of the seller to
be willing to supply more only at higher prices.
It can be seen in Fig. 1.3 that the two curves, DD and SS, intersect at
point E, and the corresponding price and quantity are P * and Q *,
respectively. This point of intersection is called the equilibrium. The
equilibrium state is a state of balance (state of balance between demand
and supply), from which there is no tendency to change. Even if the
price or the quantity deviate from this equilibrium price or equilibrium
quantity, the forces of DD and SS will make it unsustainable, and
eventually, it tends to get back to the equilibrium level. In the figure, if P
were to drift upwards from P * to P ′, the situation would be one of
imbalance, with the imbalance showing up as an excess of SS (Q S′ ) over
DD (Q ′D ). What happens to price if there is an excess supply of a good in
the marketplace? The price has to come down; it will tend back to P *.
Let us take a situation where the price falls below the equilibrium level
to P. At this price, the situation is one of imbalance, with the imbalance
showing up as an excess D (Q ′′D ) over supply (Q S′′ ). The reader must be
able to see that if the demand for a good exceeds its supply, the price will
go up, and tend back to P *. It is not difficult for the reader to visualize a
situation where the consumer, caught up in a shortage, bids up the price
and triggers off an upward pressure on price.
Thus, the point of intersection is the point of equilibrium, since it is a
state of balance from which, if either P or Q deviates, it will sooner or
later tend back to the equilibrium level. This inherent characteristic
of tending back to equilibrium automatically from any point of disequi-
librium is called stable equilibrium. The supply–demand model described
above with the demand and supply curves sloped the way they are is a
model which gives a stable equilibrium solution.
Such a solution is possible and acceptable only if the market is a level
play field with no one individual or group capable of distorting either of
the two forces. Such a solution is acceptable if the ‘market’ includes the
entire relevant population. If the market excludes the low income group
simply because they cannot afford to pay the high price which may be
arrived at by the market mechanism, then the solution may not be

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 Foundations of Managerial Economics 17

acceptable. A solution can be arrived at only if the buyers reveal their

preferences and reveal the value that they are willing to attach to the
consumption of a commodity. If they choose not to reveal, then the market
mechanism fails.
There are many situations in which the solution offered by the market
are not accepted and the regulator chooses to tinker with them. Such
situations are described in Chapter 9 in the sub-section titled ‘Interferences
with the equilibrium’.
Further, there are situations where the market mechanism’s solution is
inefficient and further still, situations where the market mechanism fails
to provide an equilibrium solution. These situations are dealt with in
Chapters 14 and 15 where situations of asymmetric information and
situations of externalities are discussed.
Definition: Equilibrium is defined as a state of balance between two
forces. Stable equilibrium is one where the forces tend towards this point
of balance constantly despite slipping off from the equilibrium.
The next related question which we need to answer is: Can equilibrium
price or quantity change to another level, or can an equilibrium shift?
This will be answered in Chapters 2 and 8 where these aspects will be
dealt in detail.

1.11 Total, Average, and Marginal Magnitudes

We now address the second analytical technique, that of optimization,

Total magnitude is the
cumulative marginal and the working tools associated with it. With the help of these working
magnitude. Marginal tools, it is possible to solve optimization problems without any in-depth
magnitude is the knowledge of calculus.
contribution made by
the last additional We will understand the concept of total, average, and marginal in rela-
unit to the magnitude tion to one magnitude—revenue. The concept, principles, and relation-
in question. Average
magnitude is the
ships amongst these will not change with the changes in magnitude. For
magnitude per unit. instance, the magnitude could be utility, product, or cost. Whatever be the
magnitude, the underlying concept and relationships will be the same.
We start by taking a hypothetical linear demand relationship for a
good, Q . The schedule of data corresponding to the hypothetical linear
demand equation given as P = 10 – Q , is listed in Table 1.1. The first two
columns of the table show the values of Q and P derived from the
hypothetical equation.
If the first two column entries are multiplied, that is, if price is multiplied
by quantity, it would give us the total magnitude which, in this case, is
the total revenue. If the seller sells two units of Q at Rs 8 per unit, he gets

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18 Managerial Economics

Table 1.1 Total, Average, and Marginal Revenue

1 2 3 4 5 6
Quantity Price Total Revenue MR MR MR
(AR) (TR) (upward (downward (better
approximation) approximation) approximation)
Average of 4 and 5

0 10 0 9 – –
1 9 9 7 9 8
2 8 16 5 7 6
3 7 21 3 5 4
4 6 24 1 3 2
5 5 25 –1 1 0
6 4 24 –3 –1 –2
7 3 21 –5 –3 –4
8 2 16 –7 –5 –6
9 1 9 –9 –7 –8
10 0 0 – –9 –

a TR of 16. It must be noted that the price is always expressed per unit.
The third column in Table 1.1 gives us the TR, which is PQ .
If PQ is the total magnitude, the revenue per unit is the average
magnitude, which will be called average revenue. So average revenue is
nothing but TR /Q or PQ /Q ≡ P . Price is, therefore, average revenue.
Column 2 of Table 1.1 is also the column corresponding to average
revenue. In terms of geometry, the relation between total magnitude
and average magnitude can be seen in Fig. 1.4. Total revenue assumes an
inverted U-shape. The average revenue is the slope of the line from the
origin to the relevant level of Q. The slope of this line is the height
TR reached along the curve divided
Total by the horizontal length represented
Revenue 25
24 24 by the distance Q. If we want to find
(TR)
21 21
AR for Q = 3, the height reached
16 16
along the TR curve is 21 and the
horizontal length represented by the
distance Q is 3. Therefore, slope of
9 9 the line from the origin to Q = 3
ΔTR along the TR curve is 21/3 = 7. The
MR ≡ limit AR thus derived is plotted in Fig. 1.5.
(as Δ →0) ΔQ
That takes us on to the definition
of marginal magnitude. Conceptu-
0 1 2 3 4 5 6 7 8 9 10 Q
ally, marginal magnitude is a change
Fig. 1.4 Total Revenue Function in the total magnitude due to the

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 Foundations of Managerial Economics 19

Rs/Q smallest possible change in the independent variable,

which here is Q . This, the reader would realize, is noth-
10
ing but the slope of the total revenue curve. Therefore,
the marginal magnitude, which here is marginal rev-
enue, is geometrically the slope along the TR curve.
To algebraically approximate the slope of the TR
curve at Q = 3, we can see what happens to TR when Q
increases by one unit from Q = 3.
0 5 10 Q The ΔTR and ΔQ are the horizontal and vertical
Fig. 1.5 MR and AR (Derived from legs of the small triangle shown between Q = 3 and
Fig. 1.4) Q = 4 in Fig. 1.4, and the slope ΔTR / ΔQ between
Q = 3 and Q = 4 is an approximation of the slope at
Q = 3, an upward approximation. We could also approximate the slope
at Q = 3 as that between Q = 2 and Q = 3. This would be a downward
approximation. The marginal revenue approximated using upward
approximation is given in Col. 4 of Table 1.1, and the downward
approximation in Col. 5. A third approximation, which is better than the
first two, is the average of the two approximations. This is given in Col. 6
of the table. In general, the approximation becomes better as we reduce
ΔQ , to get closer to the slope at a particular Q . In the limit, ΔQ has to
tend to zero. Therefore, a precise estimation of MR can now be defined
as the following:
ΔTR
MR ≡ limit
(as Δ → 0) ΔQ
This is nothing but the concept of ‘derivative’ in calculus, and thus,
marks the entry of calculus into micro and managerial economics.
To summarize, marginal magnitude is a slope measure of the total
magnitude. To get a precise measure of the slope at a particular Q , the
variation in Q has to be as small as possible, with the variation tending to
zero; this is nothing but the concept of derivative.
Now we are ready to make inferences about the values that a marginal
magnitude takes at various levels of Q and its relationship with the aver-
age magnitude.
Inference 1 When a total magnitude is rising, the corresponding
marginal magnitude is positive. This is evident from Fig. 1.4, wherein we
can see that as along as TR is increasing, the slope along the TR curve
must be positive. Using calculus, when dTR/dQ > 0, the total revenue
function is increasing, and dTR/dQ is nothing but the marginal revenue
function.

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20 Managerial Economics

Inference 2 When the total magnitude is falling, the corresponding

marginal magnitude is negative. In calculus terms, when dTR/dQ < 0,
that is, the marginal magnitude is negative, the total magnitude is
decreasing.
Inference 3 When the total magnitude reaches a maximum or a mini-
mum, the corresponding marginal magnitude is zero.
Each of these inferences can be verified with the data provided in
Table 1.1.
Inference 4 When the average magnitude falls/rises, the marginal
magnitude falls/rises at a rate faster than the average, and so will lie
below/above the average magnitude.
At this point, it is necessary to clarify the distinction between average
and marginal magnitude. The average is a per unit magnitude, while the
marginal gives the change in the total magnitude due to the smallest
possible change in Q. In other words, the ‘marginal
Rs magnitude’ gives the contribution made by the last
additional unit (called marginal unit) to the total magni-
tudes. The average magnitude distributes the contribu-
TC
tion made by the marginal unit amongst all units. Let
Point of us take a series of three numbers, say, 3, 4, 2. The average
Total Cost

Smallest
Slope of this series is 3. Now we add a marginal unit, say, 5, to
this series. The marginal unit contributes 5 to the total
and the consequence of this on the average is that the
average is now (3 + 4 + 2 + 5)/4 = 3.5.
What if the marginal unit had been 3? The new
0 Q average would have remained 3. Therefore, the aver-
age magnitude increases only when the marginal unit’s
contribution to the total is greater than the previous
Rs/Q
average. Similarly, the average magnitude falls only
Cost Per Unit (AC or MC)

when the marginal unit’s contribution is less than the

MC
previous average. It is the contribution made by the
marginal unit which pulls up or pulls down the average,
AC and hence, the fourth inference.
Inference 5 When the average magnitude is neither
rising nor falling, the marginal magnitude must be equal
to it. Figure 1.4 and the corresponding average magni-
tude captures only a part of Inference 4, since the average
Q magnitude is a declining function throughout.
Fig. 1.6 Total, Average, and Figure 1.6, where the total magnitude is the total cost,
Marginal Functions has in it both a decreasing slope and an increasing slope,

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 Foundations of Managerial Economics 21

and so captures both Inferences 4 and 5. The reader can see that when the
average cost is rising, the marginal unit lies above the average cost.
Definition: Average magnitude is the total magnitude divided by the
number of units, or it is the magnitude per unit. Marginal magnitude is
the change in the magnitude due to a change in the units.
The working tools learnt here will be used extensively in later chapters.

1.12 The Concept of Margin

The demonstration of the concept of margin for use in managerial

decision-making is a significant contribution made by microeconomics
borrowed by managerial economics.
In the face of scarcity, allocation of resources assumes great importance.
In order to maximize the benefits, satisfaction, or profit, the proponents of
the concept of margin advocate that the decision-maker should, at various
points in the decision-making process, ask whether the contribution to
the total revenue (marginal revenue) or the contribution to the total utility
(marginal utility) exceeds the contribution made by the marginal unit to
cost. Basically, the additional cost incurred is compared with the additional
benefits, and as long as the latter exceeds the former, there is an increase
in the net benefit. There are numerous situations in real life when we are
faced with situations requiring decision-making, such as whether to eat
the third cup of ice cream, whether to devote an extra eighth hour to the
study of a subject, whether to further increase the number of TV spot
advertisements, whether to produce an additional block of 100 units of
electricity, etc. All of these can be successfully tackled using the concept
of margin.
The concept of margin is, thus, the foundation of all managerial
decision-making processes. As we proceed, the reader will understand
the importance and relevance of this concept in various situations. The
reader will also be exposed to situations where ignorance of this concept
actually results in wrong decisions.
Definition: Marginal unit is the last additional unit, and the cost, utility,
or product associated with it is the ‘marginal cost’, ‘marginal utility’, or
‘marginal product’, respectively.

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22 Managerial Economics
l Managerial economics draws heavily from micro
and macroeconomics and other decision sciences.
l It applies these techniques to provide solutions
to decision-making situations faced by managers.
l The three fundamental economic problems of
what to produce, how to produce, and how to
distribute are also the decisions that managers
have to take at the firm level.
l The basic model of the theory of the firm
states that the objective of the firm is profit
maximization. There are other theories, such as
the satisficing theory.
l The circular flow model captures the working of
a simplified economic system, and enables us
to see the role of the consumer, the producer,
and the markets.
l Market mechanism provides solutions to the
choice problem faced by the consumer and the
producer.
Average Magnitude: It is the magnitude per unit.
It is computed by diving the total magnitude by
quantity.
Equilibrium: It is a state of balance from which there
is no tendency to change.
Firms: Firms produce goods using the resources
provided by households.
Households: The members of this institution are
owners of resources, which they provide to the
firms. Households also lay a demand on the goods
produced by the firms.
1. Distinguish between microeconomics, macroeco-
nomics, and managerial economics.
2. Explain the theory of the firm.
3. Why do economic profits exist?
© Oxford University Press. All rights reserved.
SUMMARY
l The invisible hand concept of Adam Smith
explains how society’s welfare is maximized even
when individuals behave selfishly to further their
own economic interests.
l The concept of opportunity cost is central to
managerial economics. This concept emerges
from the thesis that since resources are scarce,
there is always a trade off. The opportunity cost
of a resource is therefore defined as what has to
be given up in order to put a resource to the
current use.
l The problems of microeconomics and managerial
economics can be classified into two broad
categories—those requiring use of optimization
techniques, and those requiring supply–demand
analysis to arrive at equilibrium solutions.
l Equilibrium is defined as a state of balance
between supply and demand, which is graphically
represented by the point of their intersection.
KEYWORDS
Invisible Hand: It is a mechanism that ensures maxi-
mization of social benefit even when individuals
behave and take decisions independently, to maxi-
mize the individual benefit.
Marginal Magnitude: It is the change in the total
magnitude due to a unit change in quantity.
Optimization: Optimization means arriving at the
best possible state within a given set of constraints.
Profits: This is the difference between total revenue
and total cost.
CONCEPT REVIEW QUESTIONS
4. Explain the concept of invisible hand in your own
words.
5. Bring out the role of the market in the circular
flow model.
 Foundations of Managerial Economics 23

6. Classify the following examples of managerial
economic decisions under the three fundamental
economic problems—what, how, or for whom:
l Decision by an auto manufacturer to buy out
engines
l Decision by an oil refinery to get into oil explo-
ration
l Decision by Xerox whether to offer service
facilities
lDecision by a bank to computerize its operations
7. Explain the concept of equilibrium in economics.
8. In terms of the general relations among total,
average, and marginal quantities, which of the
following statements are necessarily true:
l When the total function is rising, the marginal
function is rising.
l When the total function is rising, the marginal
function is positive.
l When the total function is rising, the marginal
function lies above it.
l When the marginal function is rising, the
average function is also rising.
l When the average function is falling, the
marginal function lies below it.
l When the marginal function is neither rising
nor falling, the average function is constant.
9. Distinguish between marginal and average
magnitude.

NUMERICAL PROBLEMS
1. Mr Chris, belonging to a family whose business revenue of Rs 20,00,000. Determine the economic
has been real estate, is contemplating establishing profit/loss of this venture.
an independent real estate agency. He estimates 2. Compute the marginal and average utilities on
the expenditure on the salaries of employees to the basis of the following total utilities:
be Rs 15,00,000, and on rent, supplies, and
X 1 2 3 4 5 6
utilities to be Rs 2,50,000. He would also require
Rs 50,000 initially to be invested in assets. While TU 10 18 25 30 33 35
he is making this new business plan, he is an 3. Compute the marginal and average cost on the
employee of Leo Realtors, where his annual basis of the following total cost:
income is Rs 1,00,000. The market rate of interest X 1 2 3 4 5 6 7
is 12% per annum. He expects to generate a TC 10 18 24 29 36 45 57

1. Berle, A. and Means, C.G., 1932, The Modern
Corporations and Private Property, Macmillan,
New York.
2. Hirshleifer, J., 1983, Price Theory and Applications,
Prentice-Hall India.
3. Keat, P.G. and Young, P.K.Y., 1996, Managerial
Economics—Economic Tools for Today’s Decision
Makers, Prentice Hall.
4. Mansfield, E., Allen, W.B., Doherty, N.A., and
Weigelt, K., 2002, Managerial Economics—Theory,
Applications and Cases, W.W. Norton & Company.
REFERENCES
5. McGuigan R.J., Moyer, R.C. and Harris, F.H., 1999,
Managerial Economics: Applications, Strategy and
Tactics, International Thomson Publishing.
6. Simon, H., Theories of Decision-making in
Economics and Behavioural Science, reprinted in
Mansfield, E., 1985, Microeconomics: Selected
Readings, Fifth Edn, Norton, New York.

© Oxford University Press. All rights reserved.