1

Chapter

Techniques
Managerial Economics
Nature, Scope and Optimization

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

 Introduction
• Managerial Economics deals with the application of economic theory and decision

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

sciences that enables business mangers to take effective decisions in their business firms.
• Problems faced by business firms
• Choice of the product/service to be produced
• Price of the product/service to attain intended results and desired goal
• Methods/Technique deployed for production
• Spend towards advertisement for sales promotion
• Characteristics of Effective Business Manager
• Understand the market
• Allocate the right resource
• Decide the product/service and quantity to be produced
• Decision on price
• Maximization of profit to the business firm
2
 The Nature of Managerial Economics
• Managerial economics refers to the application of economic theory and methods of decision

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

sciences to arrive at the optimal solution to various decision making problems faced by the firm.
Business Decision
Making Problems
Decision Sciences
Optimization
Economic Theory Techniques
Macroeconomics Differential Calculus
Microeconomics Managerial Economics
Statistical Economics,
Use of Economic Theory
and Techniques of Linear Programming
Decision Sciences for Game theory
solving business
problems

Optimal solutions to
Business Decision
Problems

3
Fig 1.1 The Nature of Managerial Economics
 Roles of Managerial Economics

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• It is important to note that managerial economics has both descriptive and
prescriptive roles.
• Descriptive Role: Managerial economics not only explains how various economic forces
affect the working of a firm but also predicts the consequences of the decisions made by it.
• Prescriptive Role: Managerial economics also prescribes the rules for the improvement of
decision making by firms or their managers so that they can achieve their objectives
efficiently.
• Managerial economics deals with not only private firms but also public
enterprises. Further, the technique, approach or way of thinking of managerial
economics can also be profitably be used in non-profit making organizations
such as colleges, universities.
• This is because managers of all types of organizations face similar problems for
effective decision making.
4
Managerial Economics and Economic Theory and
Decision Sciences
• Managerial Economics uses economic theory to solve business decision problems.
Economic
Theory
Microeconomics
Deals with the theory of decision
making by individual consumers,
resource owners and business
firms.
Through its built model it can
help consumer chose the goods to
maximize his satisfaction
Price determination and output of
its product to maximize profit
Copyright © 2018 by S Chand And Company Limited. All rights reserved.
Macroeconomics
Deals with the conditions of the economy
such as level of aggregate demand, rate of
inflation, economic growth, changes in the
price level, government policies both fiscal
and monetary.
Depicts how business environment will
change as a result of movements in the
aggregate economy such as recession,
inflation etc.
5
 Decision Sciences

6
Managerial Economics and Economic Theory and

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

 Managerial Economics and Economic Theory and
Decision Sciences

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Managerial Economics uses economic theory to solve business decision problems and
decision sciences provide tools and techniques for making decision models for evaluating
the effect and results of the alternative business strategies, choices.

• Business economics uses optimization techniques including differential calculus, linear

programming etc for deriving decision rules.

7
 Nature of Managerial Decision Making

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Scarce resources and economic levels are few major constraints faced by business manages to
make managerial decisions for a firm to achieve the intended outcome and maximization of
profit for the firm.
• Make choices that are economically effective. This is constrained optimization.

Example: The objective of Maruti Udyog Limited is to maximize profits (that is, the present
value of expected returns) to be earned from expansion of output. Let S1 stand for strategy 1 or
the first course of action (that is, expanding its internal capacity), S2 for strategy 2 or the second
course of action, that is, to take over the other firm.

8
 Nature of Managerial Decision Making

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• The objective function for the above decision-making problem can be stated as
• Maximize profits (S1, S2)
• To choose from the two alternative strategies, the following decision rule can be made :
• Choose strategy S1 if profits from S1 > profits from S2.
• Choose strategy S2 if profits from S2> profits from S1.
• The above simple example only brings out the essential feature of the decision-making
problem faced by the managers of business firms and the rule for their rational solution. It
is important to note that the knowledge of economic theory for decision-making by
managers is important to formulate the objective function and to arrive at the decision rule
for choosing a strategy or a course of action that maximizes the profit.

9
 Types of Decision made by Business Managers
• Manages are required to make various business decisions as explained below:

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

1. Price and output decision:
• Price of a product will determine to a good extent how much quantity of its product it will be
able to sell. Price along with cost per unit and output sold will determine its profits.

• In deciding about price of its products, a firm has to estimate demand for its product and also
to estimate cost-output relationship.

• Its estimate of demand and production cost will determine how much quantity of output it
should produce to maximize its profit.

• Demand for a product tells the firms the quantities of a product that can be sold at various
prices, and cost-output relationship (i.e., cost function) determines the cost per unit that has to
be incurred by producing different levels of output.

10
• Thus, demand together with cost determines the profit possibilities of producing a product.
Types of Decision made by Business Managers
• Manages are required to make various business decisions as explained below:

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

2. Demand Estimation:
• Making estimates about demand for a product is crucial for achieving the objective of
profit maximization.

• To arrive at correct estimates of demand, the firm has not only to study consumer’s
behavior and their preferences but also the trends in macroeconomy regarding growth of
GNP, price situation, changes in the level of employment and balance of payments which
determine the demand for a product.

• Managers of business firms have not only to estimate current demand for their products
but also the growth of demand for their products in future.

11
 Types of Decision made by Business Managers

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

3. Choice of a Technique of Production:
• A technique of production involves the use of particular combination of factors, especially
labor and capital to produce a commodity.

• Usually various alternative techniques of producing a commodity are available among which
a firm has to choose. Some production techniques involve the use of relatively more labor as
compared to capital and are therefore called labor-intensive techniques.

• Some others use more capital relative to labor and are therefore called capital-intensive
techniques. The choice between different techniques would depend on the available supplies
of different factors of production and their relative prices.

12
 Types of Decision made by Business Managers

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

4. Advertising Decision:
• Advertisement is required to promote sales of a product, and to create wants for the new
product which is planned to be introduced in the market.

• Through advertisement management of a firm tries to influence the consumers about good
quality of its product.

• Thus, how much expenditure has to be incurred on advertisement and through what media
(Newspapers, Television, Radio, Cable TV Network etc.) is an important decision to be made
by a business firm.

• Theory of monopolistic competition and oligopoly is of great help in deciding about optimal
advertisement expenditure to be made by business firms.

13
 Types of Decision made by Business Managers

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

5. Long Run Production Decision:
• Not only the decision regarding how much quantity of output is to be produced in the short
run, but long-run decisions pertaining to production have also to be taken by firm’s
management.

• For example, where to locate the plant for manufacturing, what size of plant, that is,
magnitude of productive capacity to be built up and which technology or production
technique involving a particular factor-combination or factor proportion is to be used for
producing a product.

• Cost depends on prices of resources or inputs such as capital, labor, raw materials on the one
hand and productivity of these inputs on the other.

14
 Types of Decision made by Business Managers

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

6. Investment Decisions:
• Investment decisions relate to how much investment or capital expenditure is to be
undertaken in a period, what should be the rate of investment.

• Investment expenditure is required to expand the productive capacity, developing and

introducing new products.

• Since they are of long-run nature, investment decision precedes other decisions.

15
 Managerial Decision Making Process
• Decision making is crucial for running a business enterprise which faces a large number

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

of problems requiring decisions.

▪ Which product to be produced

▪ What price to be charged

▪ What quantity of the product to be produced

▪ What and how much advertisement expenditure to be made to promote the sales

▪ How much investment expenditure to be incurred are some of the problems which require
decisions to be made by managers
16
 Managerial Decision Making Process

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Decision making process in each of these problems contains several phases or steps as
shown in Fig 1.2(slide 18):

1. Establishing the objective

2. Defining the problem

3. Identifying possible alternative solutions

4. Evaluating alternative course of action

5. Implementing the decision

17
 Managerial Decision Making Process

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

Establishing the objective

Defining the problem

Identifying possible alternative

solutions

Evaluating alternative course of Considering Financial,

Considering legal and social
action and choosing the best Technological and
constraints
Infrastructure Constraints

Implementing the action

Fig 1.2 Managerial Decision Making Process: Various Steps 18

 Managerial Decision Making Process

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Business Firm exists for three main reasons:
1. Exploit the economies of mass production
2. Raise funds to finance its productive activities
3. Organize the production process

• Why a Firm exists: Coase’s View: Goods can be produced within a single roof
instead of individual contracts and various exchange of hands. Identified benefits are:
1. Lower transaction cost
2. Higher productivity under team work with division of labour

19
Nature of Firm: Firm as an Agent of Production

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

Input
• Labor
Output
• Raw Material • Product as per
Firm demand of
• Capital market/consumers

• Infrastructure

20
Nature of Firm: Firm as an Agent of Production

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Business Firm exists for three main reasons:
1. Exploit the economies of mass production
2. Raise funds to finance its productive activities
3. Organize the production process

• Why a Firm exists: Coase’s View: Goods can be produced within a single roof
instead of individual contracts and various exchange of hands. Identified benefits are:
1. Lower transaction cost
2. Higher productivity under team work with division of labour

21
Nature of Firm: Firm as an Agent of Production

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

1. Market Coordination: Which goods and services a firm should produce is a significant
decision a firm has to make and this decision relies on the market prices system that serves
as a source of incentives and information network.

2. Managerial Coordination or Command System:

• While commands or directions pass downward through top management to the lowest
level of workers, information passes upward.

• Top management might not have the real time or correct information every time.

• Therefore large firms deploy incentive system at various levels along with command
system to operate efficiently.

• These contracts and incentive packages are known as agency relationship. These steps
are adopted to solve what is called principal-agent problem.
22
 Organizing Productive Activity by a Firm
• Market Vs Managerial Co ordination

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• The primary objective of firms is to make maximum possible profits. Therefore, a
firm makes the above decisions in a way that minimises its cost to produce a given
level of output.

• The basic problem facing a firm is to organise the production of goods and
services by combining and coordinating the productive resources it employs.

• Production in a modern economy is based on vast division of labour and

specialization among individuals.

• For efficient production of goods a firm must coordinate the activities of the
individuals employed by it. Firms organise or coordinates its activities in the
following two ways.
23
 Boundaries of the Firm
• By boundaries of a firm we mean what parts of a product or what services a firm itself will

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

produce and what parts or services it will get from outside using the market mechanism from
other firms.
• However this differs from firm to firm Each firm tends to grow until the cost of organizing
one extra task within the firm becomes equal to the cost of organizing the same task outside
the firm through the market.
• It may be further noted that boundaries of a firm go on changing over time with technological
changes. As is now well-known many American firms are getting several services done
through Call Centers located in India, China and other developing countries.
• They are getting some services done through what is called BPO (Business Processing
Outsourcing) while earlier they provided for these services internally.
• In this way the large firms are able to concentrate on what are called ‘Core Competencies’ and
contract out to get several other components produced and services done from other
specialized firms.
• By doing so they are able to economise on transaction costs and increase their efficiency. 24
 Role and Social Responsibility of Business

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Relationship of a business firm in a society is vital to understand.

• Business firms are expected to behave in a socially responsible manner in the society and
should benefit the society in ways of socially, culturally and economically by its sheer
existence. Also, contribute to government in the form of various taxes as levied.

• Sometimes government or society have rightfully intervened to regulate these private

business firms by regulating monopoly & oligopoly by monitoring and controlling the
prices of monopolistic firms, promoting an environment of fair competition.

• Controlling cartel and collusion by Anti trust laws.

25
 Role and Social Responsibility of Business

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

Social Responsibility of Business

• First problem that has been often faced is the emergence of monopolies in free market
economies for the production of some important products or services.

• The second problem posed by free private business is the emergence of oligopoly (that is,
a few producers of a product competing with each other).

26
 Environmental Pollution

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

• Anti pollution policies to impose check on factories and companies that secrete waste and
toxic effluents in the environment that pollutes the atmosphere which leads to various health
hazard and ailments.
• Safety standards are being laid down for emission limits on manufacturing processes and
products that pollute the environment.
• Provision for heavy fines have been made who do not provide adequate safeguards. Firms
that do not meet these safety standards are even closed down.
• Society has taken to modify the profit maximizing behaviour of business firms so that they
perform their task of producing and distributing goods and service in a socially responsible
way.
• These social constraints have an important bearing on the business activities of firms and
hence on managerial decision making.

27
 Social Responsibility and Value Maximization
model of the Firm
• Societal constraints are imposed on business firm to check its impact on the society and

Copyright © 2018 by S Chand And Company Limited. All rights reserved.

environment.
• Under such policies and restrictions the firms can work in the following way to retain the
utility of its economic model and continue with their positive returns and profit:
• So far as the social efforts are confined to inducements in the form of suitable fiscal and
monetary measures such as taxes, subsidies, concessional rates of interest, these measures can
be easily incorporated in the value maximization model of the firm.
• Licensing laws, anti-pollution measures, labour laws etc. can be considered as constraints of
the model of the firms and managers have to take into account these constraints in decision
making.

▪ Thus, with the constraints imposed on the business firms so that they should operate in socially
responsible manner makes the decision-making model as one of constrained maximization of
the value of the firm.
▪ This makes the process of decision making as constrained decision making by managers.

28
29

Copyright © 2018 by S Chand And Company Limited. All rights reserved.