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Managerial Economics - handouts

Managerial Economics
Unit – I
Nature and Scope of Managerial Economics – Definition of Economics –
Important concept so Economics – Basic Economic Problem – Relationship
between Micro and Macro economics – Objectives of the Firm
Definition of Economics:
Economics:
It is the study of the way in which mankind organises itself to tackle the basic problem of
scarcity. Economics is the science which studies economics problems. There are many
definitions given by many experts the important four definitions are the basic for the economics
are
1. Science of wealth
- Adam Smith
2. Science of Material welfare
- Alfred Marshall
3. Science that Deals with Scarcity
- Lionel Robbins
4. Science of Economic Growth
- Paul A. Samuelson
Adam Smith:
Economic laws and practices have been in operation ever since human life came in existence.
Adam Smith is regarded as the “father of economics”, who first time organised and presented
economic thought in a systematic way in his book “ An Enquiry into the Nature and Causes of the
Wealth of Nations.”
This book was first published in the year 1776. This gave raise to whole new science known as
economics. This is how Adam Smith is known as the “father of economics”.
Adam Smith defined economics as “a science which studies the nature and causes of
the wealth of
nations” for Adam Smith wealth was to be-all and end-all of economic activity. This definition
came in
for sharp criticism for its narrow vision, and hence, since has largely been abandoned.
Alfred Marshall:
The great economist considered economics as a means or an instrument to better the conditions
of human life. He defines economics, “Political economy or economics is a study of mankind in
the ordinary business of life, and it examines that part of individual and social action which is
most closely connected with the attainment and with the use of the material requisites of well-
being.”
It is on the one side a study of wealth and on the other and more important side a part of the
study of
man. For Marshall wealth was only one of the ways to achieve economic welfare.
The important features of this definition is

Economics is a study of the ordinary business of life


Economics is a social science


Economics studies only the material requirements of well-being.


Managerial Economics - handouts

“Business Economics (Managerial Economics) is the integration of economic theory with


business
practice for the purpose of facilitating decision making and forward planning by management.” –
Spencerand Seegelman.
“Managerial economics is concerned with application of economic concepts and economic
analysis to
the problems of formulating rational managerial decision.” –Mans field
Nature and Scope of Managerial Economics:

The primary function of management executive in a business organisation is decision making


and forward planning.

Decision making and forward planning go hand in hand with each other. Decision making means
the process of selecting one action from two or more alternative courses of action.

Forward planning means establishing plans for the future to carry out the decision so taken.

The problem of choice arises because resources at the disposal of a business unit (land, labour,
capital, and managerial capacity) are limited and the firm has to make the most profitable use of
these resources.

The decision making function is that of the business executive, he takes the decision which will
ensure the most efficient means of attaining a desired objective, say profit maximisation. After
taking the decision about the particular output, pricing, capital, raw-materials and power etc., are
prepared. Forward planning and decision-making thus go on at the same time.

A business manager’s task is made difficult by the uncertainty which surrounds business
decision-making. Nobody can predict the future course of business conditions.

He prepares the best possible plans for the future depending on past experience and future
outlook and yet he has to go on revising his plans in the light of new experience to minimise the
failure.

Managers are thus engaged in a continuous process of decision-making through an uncertain


future and the overall problem confronting them is one of adjusting to uncertainty.

In fulfilling the function of decision-making in an uncertainty framework, economic theory can be,
pressed into service with considerable advantage as it deals with a number of concepts and
principles which can be used to solve or at least throw some light upon the problems of business
management.

E.g to profit, demand, cost, pricing, production, competition, business cycles, national income etc.
The way economic analysis can be used towards solving business problems, constitutes the
subject-matter of Managerial Economics.

Thus in brief we can say that Managerial Economics is both a science and an art.
Scope of Managerial Economics:
The scope of managerial economics is not yet clearly laid out because it is a developing science.
Even
then the following fields may be said to generally fall under Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
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These divisions of business economics constitute its subject matter.


Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc., have
also come to be regarded as part of Managerial Economics.
1.Demand Analysis and Forecasting: A business firm is an economic organisation which is
engaged in transforming productive resources into goods that are to be sold in the market. A
major part of managerial decision making depends on accurate estimates of demand. A forecast
of future sales serves as a guide to management for preparing production schedules and
employing resources. It will help management to maintain or strengthen its market position and
profit base. Demand analysis also identifies a number of other factors influencing the demand for
a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
2.Cost and production analysis : A firm’s profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are
cause variations in cost estimates and choose the cost-minimising output level, taking also into
consideration the degree of uncertainty in production and cost calculations. Production processes
are under the charge of engineers but the business manager is supposed to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing
practices depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale
and cost control.
3.Pricing decisions, policies and practices : Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The important
aspects dealt with this area are: Price determination in various market forms, pricing methods,
differential pricing, product-line pricing and price forecasting.
4.Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is
one who can form more or less correct estimates of costs and revenues likely to accrue to the
firm at different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the
most challenging area of Managerial Economics.
5.Capital management: The problems relating to firm’s capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the capital
assets off are so complex that they require considerable time and labour. The main topics dealt
with under capital management are cost of capital, rate of return and selection of projects.
Conclusion: The various aspects outlined above represent the major uncertainties
which a business
firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit
Managerial Economics - handouts

uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of
Managerial Economics consists of applying economic principles and concepts towards adjusting
with various uncertainties faced by a business firm.
Important Concepts of Economics:
Some Important concepts of Economics are:
1. Goods
2. Wealth, Capital and Income
3. Money
4. Value and Price
5. Equilibrium
6. Consumption and Wants
7. Slope or Rate of Change
1. Goods: The human wants are the starting point of all economic activity. There are two things
with which he can satisfy these wants – goods and services. Goods mean the commodities that
we use, and services refer to the work that a person may do. Services are not something tangible
or concrete. Generally “goods” refer to those material and non-material objects which satisfy
human wants. But in economics, the term is used in a narrow sense. For our purpose the “goods”
includes only those material objects which possess the following characteristics.
(i) These can be transferred from one person to another and
(ii) These can be exchanged for one another.
The most important classification of goods is as Free goods and Economic goods.
Free goods are those that exist in plenty that you can with out any payment. E.g. Air, Water,
sunshine,
etc
Economic goods are those goods which are scare and exist in limit quantity, man can have it by
paying for the goods. E.g. T.V., Washing machine, mobile phone etc., It can be further classified
into: (i) Consumer goods and (ii) Producer goods (also known as Capital goods).
(i) Consumer goods: are those goods which directly satisfy human wants, e.g. food, cloths,
house etc. It
can be classified into (a) Durable goods (b) Single-use goods
(a) Durable goods: The goods that can be consumed a number of times without any damages to
its utility and its life time is more e.g. furniture, shoes, t.v, etc
(b) Single-use goods: The goods have limited life and it gets destroyed as soon as they are
consumed e.g. food, cold drinks, vegetables, fruits etc.,
(ii) Producer goods (Capital goods): these goods that help in further production and may
durable
goods like machines, tools, etc and single use goods like raw materials, coal, fuel, etc.
2. Wealth, Capital and Income:
Wealth is the stock of all those objects-material or immaterial– which possess the following
characteristics,
(i) it must have utility
(ii) it must be scarce
(iii) it must be transferable
(iv) it must be external to human being
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All the economic goods possess the above characteristics; a stock of such goods will be called
wealth. Some immaterial objects like goodwill also form part of wealth. These are known as
immaterial wealth. Wealth can be classified into four as follows:
(i)
Personal Wealth- like buildings, ornaments, cloths etc
(ii)
Social wealth- like roads, bridges, public hospitals, etc
(iii)
National wealth- mines, forests, rivers, etc
(iv)
International wealth- like international sea- routes, air-routes etc.
Capital: It is the part of wealth which is used in the process of production like tools,
machinery, raw
materials, etc., it would be seen that all capital is wealth but all wealth is not capital.
Income: The earnings received by various factors of production- land, labour, capital
and organisation-
according to a time schedule are called income. It is obtained by producing goods, performing
services or by services or by investing.
3. Money: Money is anything that is generally acceptable as a medium of exchange and acts as
a measure of value. It is accepted in payment of goods and services. It is given and received
without reference to the standing of the person who offers it as payment. It is classified as
(i) Cash money- it includes currency notes and coins
(ii) Bank money- it consists of cheques, drafts, bills of exchange, etc.
4. Value and Price: The term ‘value’ is used to express the utility or usefulness of a commodity
or
services; the term ‘price’ is used to explain the units of money required to purchase the
commodity.
5.Equilibrium: The word Equilibrium has been borrowed from Physics. It is very frequently used
in modern economic analysis. Equilibrium means a state of balance. When forces acting in
opposite direction are exactly equal, the object on which they are acting is said to be in a state of
equilibrium. It also refers to a state when a situation is ideal or optimum or when complete
adjustment has been made to changes in an economic situation, there is no incentive for any
more change, so that no advantage can be obtained by making a change. For e.g. A consumer is
said to be in an equilibrium position when he is deriving maximum satisfaction.
A producer or a firm is said to be in equilibrium when it is making a maximum profit or incurring a
minimum loss, here there will be no inducement to change.
6. Consumption and Wants:
Consumption means the using up of goods and services in such a manner that the
wants of members of the community are satisfied, thus it may be defined as any economic activity
directed to satisfy human and his wants. If any goods are destroyed by unforeseen accidents like
earthquake, flood, wars etc it is not consumption as there is no economic purpose is served. It is
divided as Consumption of goods- there is always a time gap between production and
consumption and Consumption of services- services are consumed the moment they are
produced.
Wants means a wish or a desire. Which plays a vital role in the economic life are those
which have an urge to effort and which find their satisfaction through that effort. Wants differ in
their intensity, it can be conveniently classified into three categories as (a) Necessaries (b)
Comfort (c) Luxuries.
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7. Slope or Rate of Change: The concept of slope or rate of change is essential to gain an
understanding of many economic principles. The slope, of a line or curve is defined as the rise /
run or ∆Y / ∆X, where delta (∆) refers to a ‘change in’
From the fig the concept of slope is illustrated. The value of the slope for any segment of the
straight lineAB is 1.0. The slope of the lineAB in the figure indicates that for every 1unit change
inX there is a unit change inY.
Basic Economic Problem:
From the study of the essential processes of an economy, it would appear that some fundamental
problems arise whatever the type of economy. An economy exists because of two basic facts,
1. Human wants for goods and services are unlimited
2. Productive resources with which to produce goods and services are scare.
Wants are unlimited and resources are limited, the economy has to decide how to use its scarce
resources to give the maximum possible satisfaction to the members of the society. In doing so,
an
economy has to solve some basic problems called central problems of an economy, which are:
1. WHAT to Produce
2. HOW to Produce
3. FOR WHOM to Produce
What ever the type of economy or economic system, these problems has to be solved some how.
These
are the basic and fundamental for all economies.
1. WHAT to Produce:
The problem ‘what to produce’ can be dived into two related questions.
a. Which goods are to be produced and which not?
b. What quantities those goods, which the economy has decided to produce, are to be
produced?
If productive resources were unlimited we could produce as many numbers of goods as we like. If
the resources are in fact scarce relative to human wants, an economy must choose among
different alternative collections of goods and services that it should produce.
E.g. If it is desired to produce more wheat and less cotton, land use will have to get diverted for
cultivation of cotton to wheat.
2. HOW to Produce:

The problem ‘how to produce’ means which combination of resources is to be used for
the production of goods and which technology is to be made use of in production.

Once the society has decide what goods and services are to be produced and in what
quantities, it must then decide how these goods shall be produced. There are various alternative
methods of producing a good and the economy has to choose among them. It is always possible
Managerial Economics - handouts

to employ alternative techniques of production to produce a commodity, e.g. labour can more
generally, be substituted by machines, and vice- versa.

A choice would have to be made say between labour- intensive techniques and capital-
intensive techniques of production.

E.g. Bricks and cement can be carried by labour to the upper floors of a building under
construction. Alternatively elevators and lifts can do the job; we have to make the choice.
3. FOR WHOM to Produce:

‘For whom to produce’ it means how the national product is to be distributed


among the members of the society, who should get how much of the total amount of goods and
services produced in the economy.

The third problem of sharing of the national product, Distribution of the national
product depends on the distribution of national income. Those people who have larger incomes
would have larger capacity to buy goods and hence will get greater share of goods and services.
Those, who have low incomes would have less purchasing power to buy things. The more equal
is the distribution of income, the more equal will be the distribution of the national product.
The question arises how is the national income to be distributed, that is, how is it to be
determined as to who should get how much of the national income? Should the people get equal
incomes and hence equal shares from the national product, or whether the distribution f national
income should be done on the basis of the Marxian principle ‘from each according to his ability, to
each according to his needs’ or should the distribution of national income be in accordance with
the contribution made to the total production, that is, should everybody get income exactly equal
to what he produces?
The main difficulty in the question of distribution of national product or income is how to reconcile
the equity and justice aspect of distribution with the incentive aspect. From the point of view of
equity distribution of national product or income n the basis f equality seems to be the best that
the problem is that equality in the distribution of national product or income may adversely affect
the incentive to produce more. If this incentive is destroyed or greatly diminished as a result of
promoting equality, the total national output available for sharing may be so much smaller that the
living standards of all may go down.
The Micro Economics and Macro Economics:
Economic analysis is of two types (a) Micro economic analysis and (b) Macro economic analysis
1. Micro economics :
Definition:
According to E. Boulding, “Micro economics is the study of particular fir, particular household,
individual price, wage, income, industry, and particular commodity.”
In the words ofL eftwitch, “Micro economics is concerned with the economic activities of such
economic units as consumers, resource owners and business firms.”
o

‘Micro’ is a Greek word means ‘small’


o

Micro economic theory studies the behaviour of individual decision-making units such as
consumers’ resource owners, business firms, individual households, wages of workers, etc
o

It studies the flow of economic resources or factors of production from the resource owners
to business firms and the flow of goods and services from the business firms to households. It
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studies the composition of such flows and how the prices of goods and services in the flow
are determined.
o

In this analysis economists pick up a small unit and observe the details of its operation.
o

It provides analytical tools for the study of the behaviour of market mechanism.
o

It is also called as Price theory and


o

It is also called as Partial Equilibrium analysis.


Importance of Micro economics:
o

Micro economics occupies a very important place in the study of economic theory.
o

It has both theoretical and practical importance.


o

It explains the functioning of a free enterprise economy


o

It tells how millions of consumers and producers in an economy take decisions about the
allocation of productive resources among millions of goods and services.
o

It explains how through market mechanism goods and services produced in the community
are distributed
o

It explains the determination of the relative prices of the various products and productive
services.
o

It helps in the formulation of economic policies calculated to promote efficiency in


production and the welfare of the masses.
Limitations:
 It cannot give an idea of the functioning of the economy as a whole. An individual
industry
may be flourishing, where as the economy as a whole may be languishing
 It assumes full employment which is a rare phenomenon, at any rate in the
capitalist world.
Therefore it is an unrealistic assumption
2. Macro economics:
Definition:
According to E. Boulding “Macro economics deals not with individual quantities as such
but with aggregates of these quantities, not with individual income but with national income not
with individual prices but with price levels, not with individual outputs but with national output.”
According to Gardner Ackely, “Macro economics concerns with such variables as the
aggregate volume of the output of an economy, with the extent to which its resources are
employed, with the size of national income and with the general price level.”

Macro economics is the obverse of microeconomics.


It is the study of economic system as a whole.


It studies not one economic unit like a firm or an industry but the whole economic system

Therefore it deals with totals or aggregates national income output and employment, total
consumption, saving and investment and the genera level of prices.

It is also called as Income theory and


It is also called as aggregative economics.


Importance:
Managerial Economics - handouts
 It helps in understanding the functioning of a complicated economic system
 It gives a bird’s eye view of the economic world
 For the formulation of useful economic policies for the nation macro economics is
of the utmost
significance.
 It is far more fruitful to regulate aggregate employment and national income and
to work out a
national wage policy
 It occupies most important place in economic theory in its pursuit of the solution
of urgent
economic problems.
Limitations:
o

Individual is ignored altogether. It is individual welfare which is the main aim of economics.
o

It overlooks individual differences. Say the general price level may be stable, but the price of
food grains may have gone spelling ruin to the poor.
Difference between Micro economics and Macro economics:
The main differences between micro economics and macro economics are the following:

S. No. Micro economics Macro economics


01 Difference in the It studies the individual units of It deals with aggregates like
degree of the economy like a firm, a national income and aggregate
aggregation: particular commodity. savings. It studies the problem
of the economy as a whole
02 Difference in It is to study of principles, It studies the problems, policies
objectives problems and policies and principles relating full
concerning the optimum employment of resources and
allocation of resources growth of resources.
03 Difference of subject It deals with the determination It is full employment, national
matter of price, consumer’s income, general price-level,
equilibrium, distribution and trade cycles, economic growth,
welfare, etc. etc.
04 Method of study Micro economics laws establish Macro economics elements are
relationship between the categorized into aggregate units
causes and effects of like aggregate demand,
economics phenomena and it is aggregate supply, total
formulated by taking some consumption, total investment,
assumptions. etc.
05 Different It analysis how production and It analysis how full employment
assumptions factors of production are can be achieved.
allocated among different uses
06 Difference of the It studies the equilibrium It deals with equilibrium
forces of between the forces of individual between the forces demand and
equilibrium demand and supply or market supply of whole economy.
demand and supply.
Managerial Economics - handouts

Unit – II
Demand Analysis – Theory of consumers behaviour – Marginal Utility
Analysis – Indifference curve analysis -Meaning of Demand – Law of Demand
– Types of Demand – Determinants of demand – Elasticity of Demand –
Demand Forecasting.
Demand Analysis: Theory of Consumer behaviour:
Introduction:
o

For taking appropriate decisions, the decision-makers require an adequate knowledge about the
Market conditions, specially of the relevant segment of the Market.
o

The Market has two sides, viz Demand and Supply. Demand and Supply also called as Market
forces and “invisible hands”.
o

Demand may be classified as Individual Demand and Market Demand


o

We have to analyse the basic principles underlying the consumer demand.


o

The factors which govern consumer behaviour, i.e how does a consumer decide ‘what to buy’
and ‘how much to buy’. These questions take us to the Theory of Demand.
o

Utility of the consumer goods is the basis of consumer demand. It is therefore useful to examine
first the concept and the law of utility.
Meaning of Utility:
“Utility is the power or property of a commodity to satisfy human desires.” People pay for
a commodity for its want-satisfying quality. The want-satisfying property of a commodity is
‘subjective’, not ‘objective’. That is whether a commodity is useful for a person or not, it depends
on her/his need for that commodity or not. Utility is often user-specific. A commodity need not be
useful for all. The Utility of commodity varies from person to person and from time to time
depending on the urgency or intensity of their respective needs.
“Utility” and “Satisfaction” are different. The former stand for ‘expected satisfaction’
where as the latter ‘satisfaction realized’. Consumer wants to buy a commodity he thinks about
the utility of the commodity or how much of satisfaction the commodity is capable of giving. Only
after purchasing he/ she realize the ‘satisfaction’. When ‘expected satisfaction’ is not realized
after consumption, it would decide the consumer to choose or not the commodity in future.

Consumer Theory:
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There are two basic approaches to discuss the consumer demand theory. This theory is taken
from the mathematics:
1. Cardinal utility approach or Classical approach or Neo-classical approach: - which utility
(satisfaction) has been made measurable. That is the utilities contained in commodities are made
quantifiable.
2. Ordinal utility approach or Indifference Curve Analysis- It dispenses with measurement of utility or
comparing utility in quantities as this is not a realistic one and takes up the analysis of the
preference of the consumer. On the basis of the preferences, the commodities are ordered or
ranked as first, second, third, etc.
Concepts of Total and Marginal Utility:
Total Utility is the amount of satisfaction derived from the consumption of or possession
of a commodity. That is total utility is the total satisfaction derived in consuming all the quantities
of commodity purchased.
Marginal Utility is the Utility or satisfaction derived from one unit of that commodity.
Definition- Prof. Bouldiing, “Marginal Utility of any quantity of commodity is the increase in the
total utility which results from a unit increase in consumption.”
“Marginal Utility is the rate of change of total utility caused by a small given change in
the quantity of the commodity.”
E.g. A consumer purchases a packet of biscuits. Total utilities or satisfaction derived refers to the
utilities of all biscuits in the packets.
Marginal utility refers to a single biscuit in the packet. If all biscuits in the packet is alike, then
marginal utility is
Total Utility
Total Utility = ____________
Total quantit

This may be stated in a different way; suppose the consumer consumes ‘m’ units of a commodity
then
the aggregate of the utilities derived from ‘m’ units may be referred to as the total utility of ‘m’
units.
The marginal utility of ‘m’ units of a commodity is the difference between the total utilities of (m+1)
and ‘m’ units, (or) (m-1) units.
Marginal utility is the utility of the “Marginal unit”
Marginal unit may be an additional unit or one extra unit or the last unit.
Since Managerial utility is the change in total utility due to an additional unit. It can be expressed
mathematically by;

Dux
Mux = --------
Dqx