Unit - 1

Introduction to Managerial Economics

Chapter Overview
• Definition

• Functions of Managerial Economics

• Nature of Managerial Economics

• Scope of Managerial Economics

• Managerial Economics as art and science

• Managerial Economics relationship with other subjects

• Principles or tools of Managerial Economics

Definition
According to Spencer and Siegelman

“The integration of economic theory with business practice for the purpose of facilitating decision making and

forward planning by management”

Prime Functions of Managerial Economics

• Decision Making

The Process of selecting one action from two or more alternative courses of action.

• Forward Planning

Establishing Plans for the future.

 Economics-

Theory and

Methodology

Business

Management

- Decision
Managerial
Problem
Economics-

Application of

Economics to

solving business

Problems

Explanation
It is sometimes referred to as:

Business Economics, and is a branch of economics that applies microeconomic analysis to decision methods of

businesses or other management units.

More Explanation
As such,

It bridges economic theory, and economics in practice It draws heavily from quantitative techniques such

as regression analysis, correlation and calculus.

And some more Explanation

If there is a unifying theme that runs through most of managerial economics, it is the attempt to optimize business

decisions given the firm's objectives and given constraints imposed by scarcity,

F or Example
• through the use of operations research,

• mathematical programming,

• game theory for strategic decisions, and

• other computational methods.

Nature of Managerial Economics

1. A r t and Science: Managerial economics requires a l ot of logical thinking and creative skills for decision making

or problem-solving. It is also considered to be a stream of science by some economist claiming that it involves

the application of different economic principles, techniques and methods, to solve business problems.

2. M u lti-disciplina r y : It uses many tools and principles belonging to various disciplines such as accounting, finance,

statistics, mathematics, production, operation research, human resource, marketing, etc.

3. M i cro Economics: In managerial economics, managers typically deal with the problems relevant to a single entity

rather than the economy as a whole. It is therefore considered an integral part of microeconomics.
4. M a nagement O riented: This serves as an instrument in managers’ hands to deal effectively with business-

related problems and uncertainties. This also allows for setting priorities, formulating policies, and taking

successful decision-making.

5. Pr escriptive/Normative Discipline: By introducing corrective steps it aims at achieving the objective and solves

specific issues or problems.

6. M a nagerial economics is helpful in optimum resource allocation; The resources are scarce with alternative uses.

Managers need to use these limited resources optimally. Each resource has several uses. It is manager who

decides with his knowledge of economics that which one is the preeminent use of the resource.

Scope of Managerial Economics

Scope
1. Demand Analysis and Forecasting

2. Cost Analysis

3. Production and Supply Analysis

4. Pricing decisions, policies and practices

5. Profit Management

6. Capital Management

Demand Analysis and Forecasting

• Accurate decisions of demand

• Preparation of production schedule

• Resources Employed

• Forecast future sales

• To strengthen market position

• Planning profit

Important topics:

-Demand Determinants

-Demand Distinction
 -Demand Forecasting

Cost Analysis
• a study of economic cost

• combined with

• data drawn from the firm’s accounting records

• can yield significant cost estimates

• useful for mgt decisions

• Topics covered are:

- Cost concept and Classification

- Cost-output relationship

- Cost Control

- Cost Reduction

Production and supply analysis

Microeconomic techniques are used to

• analyze production efficiency,

• optimum factor allocation,

• costs,

• economies of scale, and

• to estimate the firm's cost function.

Managerial Decision can be applied to:

Pricing decisions, policies and practices

-Microeconomic techniques are used to analyze various pricing decisions including

• transfer pricing,

• joint product pricing,

• price discrimination,

• price elasticity estimations, and

• choosing the optimum pricing method.

Profit Management
• Nature and measurement of profit

• Profit Policies

• Techniques of Profit planning

• A business firm is an organization designed with an intention to make profits and profits reflect the success of

a company. After all the analyses, it all rolls down to profits.

• To maximize profits a firm needs to manage certain things like pricing, cost aspects, resource allocation, and

long-run decisions. This would mean that the firm should work from the very beginning, evaluate its investment

decisions and frame the best capital budgeting policies. Profit management is considered as a difficult area of

managerial economics.
• The important aspects covered under this area are: nature and measurement of profit, profit policies, and

techniques of profit planning like br eak-even analysis, cost-volume-profit analysis, etc.

Capital Management
- Investment theory is used to examine a firm's capital purchasing decisions

• Planning and Control of Capital expenditure

• Determining Cost of Capital

• Determining Rate of Returns

• Selection of Projects

Difference between Economics/Traditional Economics & Managerial Economics

Managerial Economics as Art and Science

Managerial economics as Art

Managerial economics requires a lot of logical thinking and creative skills for

decision making or problem-solving.

Art helps to develop the best way of doing things.

Managerial economist should have an art to put in practice his theoretical knowledge

regarding elements of economic environment.

Managerial economics as science

It is also considered to be a stream of science by some economist claiming that it involves the application of different

economic principles, techniques and methods, to solve business problems.

M a nagerial economics is science as establish relationship between causes and effects.

Managerial Economics relationship with other subjects

Introduction
Managerial Economics has gained strength to be a separate branch of knowledge.

Its strength lies in its ability to integrate ideas from various specialized subjects to gain a proper perspective for

decision-making.

Management Theory and Accounting

• Managerial Economics has been influenced by the developments in management theory and accounting

techniques.

• Accounting refers to the recording of pecuniary transactions of the firm in certain books.

• Profit maximization is the major objective of the firm.

• Managerial Economics requires a proper knowledge of cost and revenue information and their classification.

• Generation, interpretation and use of accounting data.

This has resulted in a new specialized area of study called "Managerial Accounting".

Managerial Economics and Mathematics

• Mathematics is significant for managerial economics in view of its profit maxi mization goal long with optional use

of resources.

• The major problem of the firm is

o how to minimize cost,

o how to maximize profit, or

o how to optimize sales.

• Mathematical concepts and techniques (Geometry, Algebra and calculus) are widely used in economic logic to

solve these problems.

• Also, mathematical methods help to estimate and predict the economic factors for decision making and forward

planning.

Managerial Economics and Statistics

• Managerial Economics needs the tools of statistics in more than one way.

• A successful businessman must correctly estimate the demand for his product.

• He should be able to analyses the impact of variations in tastes.

Statistical Applications
• S ta tistical tools l ike the theory of pr obability a n d forecasting techniques help the fi rm to pr edict the future

cou rse of events.

• Use of correlation and multiple regressions in related variables like price and demand to estimate the extent of

dependence of one variable on the other.

• The theory of probability is very useful in problems involving uncertainty.

Managerial Economics and Operations Research
• Taking effectives decisions is the major concern of both managerial economics and operations research.

• The development of techniques and concepts such as linear programming, inventory models and game theory is

due to the development of this new subject of operations research in the postwar years.

• Operations research is concerned with the complex problems arising out of the management of men, machines,

materials and money.

OR Application
Operation research provides a scientific model of the system and it helps managerial economists in the field of

• product development,

• material management,

• inventory control,

• quality control,

• marketing and

• demand analysis.

The varied tools of operations Research are helpful to managerial economists in decision -making.

OR Application
• Fashion and changes in income on demand only then he can adjust his output.

• Statistical methods provide and sure base for decision-making.

• Thus, statistical tools are used in collecting data and analyzing them to help in the decision-making process.

Managerial Economics and Computer Science

• Computers have changed the way of the world functions and economic or business activity is no exception.

• Computers are used in data and accounts maintenance, inventory and stock controls and supply and demand

predictions.

• What used to take days and months is done in a few minutes or hours by the computers.

• Infact computerization of business activities on a large scale has reduced the workload of managerial personnel.

• In most countries a basic knowledge of computer science, is a compulsory programme for managerial trainees.

Conclusion
A successful managerial economist must be a ma thematician, a statistician and an economist.

He must be also able to combine philosophic methods with historical methods to get the right perspective only then;

he will be good at predictions.

Fun damental Tools of Economics

Opportunity Cost Principle

In microeconomic theory,

The opportunity cost of a choice is the value of the best alternative forgone in a situation in which a choice needs

to be made between several mutually exclusive alternatives given limited resources.

Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking

the second-best choice available.

The New Oxford American Dictionary defines it as

 " T he l oss of potential gain from other alternatives when one alternative is chosen". and has been described

as expressing "the basic relationship between scarcity and choice".

Importance of Opportunity Cost Principle

• Ensuring scarce resources are used efficiently.

• Opportunity costs are not restricted to monetary or financial costs:

• the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be

considered opportunity costs.

Opportunity costs in consumption

Opportunity cost may be expressed in terms of anything which is of value.

For example, an individual might decide to use a period of vacation time for travel rather than to do household

repairs. The opportunity cost of the trip could be said to be the forgone home renovation.

Opportunity costs in production

If the workers on a farm can produce either one million pounds of wheat or two million pounds of barley, then the

opportunity cost of producing one pound of wheat is the two pounds of barley forgone.

Explicit costs
• Opportunity costa that involves direct monetary payment by producers.

• The opportunity cost of the factors of production not already owned by a producer is the price that the

producer has to pay for them.

For instance, a firm spends $100 on electrical power consumed, their opportunity cost is $100. The firm

has sacrificed $100, which could have been spent on other factors of production .

Implicit Cost
• Implicit costs are the opportunity costs in factors of production that a producer already owns.

• They are equivalent to what the factors could earn for the firm in alternative uses, either operated within

the firm or rent out to other firms.

For example, a firm pays $300 a month all year for rent on a warehouse that only holds product for six

months each year.

The firm could rent the warehouse out for the unused six months, at any price (assuming a year -long lease

requirement), and that would be the cost that could be spent on other factors of production.

Non-monetary opportunity costs

• Opportunity costs are not always monetary units or being able to produce one good over another.

• The opportunity cost can also be unknown, or spawn a series of infinite sub opportunity costs.

For instance, an individual could choose not to ask a girl out on a date, in an attempt to make her more

interested, but the opportunity cost could be that they get ignored - which could result in other opportunity being

lost.

Incremental Principle
• The incremental concept is closely related to the marginal costs and marginal revenues of economic

theory. Incremental concept in managerial economics involves two important activities which are as follows:
• Estimating the impact of decision alternatives on costs and revenues.

• Emphasizing the changes in total cost and total cost and total revenue resulting from changes in prices, products,

procedures, investments or whatever may be at stake in the decision.

• The two basic components of incremental reasoning are as follows:

• Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision.

• Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular

decision.

• T he incremental principle i n economics may be stated as under

• A decision is obviously a pr ofitable one if;

• It increases revenue more than costs

• It reduces costs more that revenues.

• It decreases some costs to a greater extent than it increases other costs

• It increases some revenues more than it decreases other revenues.

Marginal Principal
• Marginal generally refers to small changes.

• Marginal revenue is change in total revenue per unit change in output sold.

• Marginal cost refers to change in total costs per unit change in output produced (While incremental cost refer s

to change in total costs due to change in total output).

• The decision of a firm to change the price would depend upon the resulting impact/change in marginal revenue

and marginal cost. If the marginal revenue is greater than the marginal cost, then the firm should bring about the

change in price.

Principle of Time Perspective

Description
A ma nger/decision maker should give due emphasis, both to short-term and long-term impact of his decisions giving

a ppropriate significance to the different time periods before reaching any decision.

Short-run
Short-run refers to a time period in which some factors are fixed while others are variable.

The production can be increased by increasing the quantity of variable factors.

Long-run
While l ong-run is a time period in which all fa ctors of production can become v a riable.

Entry and exit of seller firms can take place easily.

Discounting Principle

Meaning
Determine the value of something in the future compared to its present-day value.

Reason being, an amount of money you have in your hands today is worth more than money you have at some future

time.

You would rather have $100 today than wait until tomorrow for the same amount of money.

Discounting Principle Defined

To look at the value of a sum of money in the present day and compare it to the value of the money after an amount

of time.

You need to do this if you are in a situation where you will use the money at a future date.

T he value of the future amount of money is known as the Present Value.

Present Value
To find the present value, you need to discount the amount of interest the money could earn if you were to place it

in an interest earning account.

PV formula
The formula used to find the discount factor is:

Equi-marginal Principle
• Marginal Utility is the utility derived from the additional unit of a commodity consumed.

• A consumer will reach the stage of equilibrium when the marginal utilities of various commodities he consumes

are equal,

• According to the modern economists, this law has been formulated in form of law of Proportional Marginal

Utility.

• It states that the consumer will spend his money-income on different goods in such a way that the marginal utility

of each good is proportional to its price, i.e.,

MUx / Px = MUy / Py = MUz / Pz

Where,

MU represents marginal utility and

P is the price of good.

Principle of risk and uncertainty

While taking decision a business executive has to face these important situations i.e.

• Risk

• Uncertainty

R isk - Risk is present when future events occur with measurable probability. Basically, Economic risk is the chance

of loss because all possible outcomes and their probability of happening are unknown

Un c ertainty -uncertainty is present when the likelihood of future events is indefinite or incalculable. Uncertainty

exists when the outcomes of managerial decisions cannot be predicted with absolute accuracy but all possibilities

and their associated probabilities are known.

Principle of Scarcity
• Scarcity refers to the gap between limited resources and unlimited wants.

• For Example – Scarcity of job = Unemployment

• It simply means the situation at which demand is high and supply is low of goods and services.

• So, at this situation people require to make decisions about how to allocate resources efficiently, in order to

satisfy basic needs.