Mrs.

Nisha Pandey Assistant Professor (Managerial Economics)

UNIT-I
Introduction
Managerial Economics, also called Business Economics, is the application of economic theory
and methodology to business. Business involves decision-making. Decision making means the
process of selecting one out of two or more alternative courses of action. The question of choice
arises because the basic resources such as capital, land, labour and management are limited and
can be employed in alternative uses.
Managerial economics generally refers to the integration of economic theory with business
practice. While economics provides the tools, which explain various concepts such as Demand,
Supply, Price, Competition etc. Managerial Economics applies these tools to the management
of business. In this sense, Managerial Economics is also understood to refer to business
economics or applied economics.
Economics is the study about making choices in the presence of scarcity. The notions,
‘Scarcity’ and ‘Choice’ are very important in Economics. If the things were available in plenty
then there would have been no choice problem, you can have anything you want. The point is
that problem of choice arises because of scarcity. The study of such choice problem at the
individual, social, national and international level is what Economics is about. Thus, Economics
as a social science, studies the human behaviour as relationship between numerous wants and
scarce means having alternative uses. Economics, as a basic discipline, is useful for certain
functional areas of business management.
Managerial economics is an applied microeconomics. It bridges the gap between abstract
theories of economics in the managerial decision-making. So, managerial economics is an
application of that part of microeconomics, focusing on those topics of the greatest interest and
importance to managers. The topics include demand, demand forecasting, production, cost, cost
function, pricing, market structure and government regulation. A strong grasp of the principles
that govern the economic behaviour of firms and individuals is an important managerial talent.
In general, managerial economics can be used by the goal-oriented manager in two ways. First,
given an existing economic environment, the principles of managerial economics provide a
framework for evaluating whether resources are allocated being efficient within a firm.

Meaning and Definition of Managerial Economics

Managerial Economics is the application of economic theory and methodology to decision-
making processes within the enterprise.
Hailstones and Rothwell defined managerial Economics as “Managerial Economics is
the application of economic theory and analysis to practices of business firms and other
institutions.
According to McNair and Merian say that “managerial economics consists of the use
of economic modes of thought to analyse business situations”.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Spencer and Siegelman defined Managerial Economics as “the integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning by
the management”.
According to Prof. Evan Douglas “Managerial Economics is concerned with the
application of economic principles and methodologies to the decision-making process within
the firm or organization under the conditions of uncertainties”
According to Prof. Hague: Managerial Economics is concerned with using logic of
economics, mathematics & statistics to provide effective ways of thinking about business
decision problems.
Prof. Joel Dean: “The purpose of Managerial Economics is to show how economic
analysis can be used in formulating business polices.”
Prof. Mansfield: “Managerial Economics attempts to bridge the gap between the purely
analytical problems that intrigue many economic theories and the problems of policies that the
management must face.”
In general, Managerial Economics could be defined as the discipline which deals with the
application of economic theory to business management.

Nature of managerial economics

• Managerial Economic is a Science: We know that science is systematic body of
knowledge and proved. On the other hand, M.E is also science because the principles and
theory of Managerial Economics is proved. Which is applicable for all level of Organization
and theory of demand, theory of price, theory of profit, theory of capital is also proved, so we
can say that managerial economic is science.

• Managerial economic is an art: Managerial economics is an art because an art is

application of skills can used for the purpose of getting some relevant information and the
other, In M.E theory is implemented in Practice way in M.E managerial skills is implemented.
So, ME is an art.

• M.E for administrations of Organization: Managerial economic for administration

of organization because administration give the relevant data. They find out the problem and
solve the problem immediately in organisation and the admin decide the target on the basis of
price, Quality of the products, Demand of product. Administration forecast the demand
according to the situation of present demand of the market.

• M.E is helpful in optimum resources allocation: In the organization are limited

resources and these resources can used in several places at a time by the tools and techniques
of managerial economic. The resources will used to get optimum output. In the organisations
our ultimate objective to earn profit so the limited resources used in such a way to get
maximum profit because, resources are limited. Our resources in human and non-human
resources. Human resources that mean labour, employees, and non-human resources that
means land, building, machine, raw materials Etc.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

• Managerial economic has component of micro economic: Managerial economics

has component of Microeconomics. A. It is related with the internal factors of organization.
Internal factor of the organisations is demand of the products, purchasing the raw materials,
how to use the resource to get maximum profits. These are related with micro component of
M.E.

• Managerial economic has components of macro-economic: Managerial

economic has a component of macro-economic which is related with the outside of the
organisation or an external factor of the organisation. External factor of the organisation is
competition market, nature of business, Government rules and regulations, industrial law,
Industrial Policies, Taxes these are the External factor of the organisation and these types of
problems solved by the managerial economics.

• Managerial economic is dynamic in nature: Managerial economics is dynamic in

nature that means managerial economics is used all space of the organisation and all except of
the organisation. By the tools and technique of managerial economic to give the relevant
information and to solve the problem of the organisations So, Managerial economic is
dynamic in nature.

Scope of Managerial Economics

Scope of the subject is said to be an extent of coverage of the subject concerned or boundaries
within which subject is set in and the importance of the subject. Managerial Economics,
among others, embraces following important aspects.
➢ Demand Analysis and Forecasting
➢ Production and Cost Analysis
➢ Pricing Decisions, Policies and Practices
➢ Capital Management, and
➢ Profit Management
Though the above ones are treated as subject matter of Managerial Economics, in the recent
years some of the techniques like Linear Programming, Input-output analysis, etc. are also
become the part of the subject.
1. Demand Analysis and Forecasting
Demand is a starting force for any business firm to emerge. A business firm is an economic
organism, which transforms productive resources into goods, and services that are to be sold
in a market. So, a major part of managerial decision-making depends on accurate analysis of
demand. Demand analysis helps identify the various factors influencing the demand for firm’s
product and thus provides guidelines to manipulating demand. Hence, Demand analysis and
forecasting, therefore, is necessary for business planning and occupies a strategic place in
Managerial Economics.
2. Production and Cost Analysis
In the competitive environment, business firms are forced to produce goods and services with
cost effectiveness. Production function and cost analysis enable the firms to achieve these
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

goals. The factors of production may be combined in a particular way to yield maximum
output. In case the prices of inputs shoot up, a firm is forced to work out a least cost
combination of inputs in producing a particular level of output. Along with the above, a study
of economic costs, combined with the data drawn from the firm’s accounting records can yield
significant cost estimates that are useful for managerial decisions. The suitable strategy for the
minimization of cost could be evolved.
3. Pricing Decisions, Policies and Practices
The success of a business firm mainly depends on the sound price policy of the firm. The price
policy of the firms determines its sales volume as well as its revenue.
Price X Sales volume = Gross Revenue of the firm
Therefore, pricing is very important area of Managerial Economics. Important aspects dealt
with under this area are Price and output determination in various Market forms, pricing
methods, Differential pricing, Product line pricing and so on.
4. Capital Management
Capital is one of the most important factors of production. In developing countries like India, it
is a limiting factor on the economic development. It is to be managed more efficiently for the
overall development of the economy as well as for the prosperity of the firm. A firm’s capital
management is most troublesome and complex activity of business management. This kind of
capital management implies planning and control of capital expenditure. The major areas dealt
here are Cost of capital, Rate of return and selection of projects.
5. Profit Management
All kinds of business firms generally organized for the purpose of making profits. In the
long-run profits provide the chief measure of success. An element of risk deserves place
at this point. Profit analysis becomes an easy task in the absence of risk. However, in the
Business Economics business it is difficult to assume something without risk. The
important aspects covered under this are: Nature and measurement of profit, Profit
policies.
The above-mentioned aspects represent the major uncertainties, which a business firm
must reckon with. Thus, Managerial Economics is application of economic principles and
concepts towards adjusting with various uncertainties faced by a business firm.
• Managerial Economics and its Relationship with Other Disciplines
Managerial Economics is an interdisciplinary course. In fact, most of the management courses
are of that sort. Managerial economics is linked with various other fields of study. Subjects
like Economics, Statistics, Mathematics, and Accounting deserve greater emphasis in this
regard. However, the relation of Managerial Economics is not confined only to them.
Managerial Economics and Economics: Managerial Economics is widely understood as
economics applied to managerial decisions. It may be viewed as a special branch of
economics, functioning as bridge between economic theory and managerial decisions.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Microeconomics, one of the main divisions of economics, is main source of concepts and
analytical tools for managerial economists. To illustrate, concepts such as elasticity of
demand, elasticity of production, demand forecasting, marketing forms, production function
etc. are of great significance to managerial economists. Thus, it is felt that the roots of
managerial economics spring from micro-economic theory. The chief contribution of
macroeconomics is in the area of forecasting of general business conditions. The modern
theory of income and employment has direct implications for forecasting general business
conditions.
1- Managerial Economics and Statistics:
Economics in general, Managerial economics in particular deals with quantifiable variables.
Quantification and estimations play crucial role in managerial economics. Therefore,
application of statistics in Managerial Economics helps in decision-making in several ways. It
helps in the estimation of demand function, which in turn helps in demand forecasting.
Similarly, statistics is also useful in the estimation of production and cost functions.
Estimation of price index relays heavily on statistical tools. In this way Managerial Economics
is heavily rely on statistical methods.
2-Managerial Economics and Mathematics:
Mathematics is another important discipline closely related to Managerial Economics. It is
again because managerial economics is quantifiable. Knowledge of geometry, calculus and
matrix-algebra is not only essential but certain mathematical concepts and tools such as
Logarithms and Exponentials, Vectors and so on are the tool kits of managerial economists. In
addition, Operations Research is also closely related to Managerial Economics, used to find
out the best of all possibilities. Linear Programming is an important tool for decision-making
in business and industry as it can help in solving problems like determination of facilities on
machine scheduling, distribution of commodities and optimum product mix etc. Input-output
analysis is also very much useful in managerial economics. Thus, there is close relationship
between Managerial economics and Mathematics.
4-Managerial Economics and Accounting:
Accounting mainly deals with systematic recording of the financial reports of business firms.
As a matter of fact, accounting information is one of the principal sources of data required by
a managerial economist for his decision-making purpose.
For example, the profit and loss account of a firm tells how well the firm has done and the
information it contains can be used by a managerial economist to throw light on the present
economic performance of the firm and future course of action. It is in this context that the
growing link between management accounting and managerial economics deserve special
mention. The main task of the management accountants now seen as being to provide the sort
of data which manager needs if they are to apply the ideas of managerial economists to solve
the business problem.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

• Micro and Macro Economics:

Economics could be broadly classified into two categories:
1) Macro-economics and
2) Micro-economics.
Macroeconomics is the study of the economic system ass whole. Microeconomics, on the
other hand, focuses on the behaviour of the individual economic activity, firms and
individuals and their interaction in markets.

Micro-economics

• Meaning of Microeconomics:
The Microeconomics is the study of firms, particular households, individual prices, wages,
income, individual industries and particular commodities. Microeconomics is also called as
study of price theory. It is related to the analysis of price determination and the allocation of
resources of specific uses. It is the study of the economic actions of individuals and small groups
of individuals.

• Definition of Microeconomics:
According to Ackley: “Microeconomics deals with the division of total output among industries,
products and firms and the allocations of resources among competing groups. It considers
problems of income distribution. Its interest is in relative prices of particular goods and
services.” It is a microscopic study of the economy.

• Scope of Microeconomics:
If we analyse and see the various aspects of Microeconomics it can be said that under the
preview on Microeconomics Price and Value theory, the theory of household, the firm and the
industry and most production and welfare theory are of the Microeconomics aspects. Thus, the
studies of Microeconomics are:
1. In the production of goods and services and how resources are allocated.
2. How the distribution of goods and services are made among the people.
3. With how much efficiency this distribution takes place.

The allocation of resources of the production of a particular goods depends upon the prices of
other goods and the prices of factors producing the goods. It means the relative prices of goods
and services determine the allocation of resources. Further, any allocation of resources on the
quantity of production is determined i.e., what should be produced, how to produce and how
much to produce.
Micro-economics is called the study of price theory, i.e., how the price of a particular
commodity like rice, tea, milk, fans etc. is determined. Again, it also studies, how wage and
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

interest are determined. The analysis of price-determination and allocation of resources are
determined under three different stages:
(a) The equilibrium of individual consumers and producers,
(b) The equilibrium of a single market, and
(c) The simultaneous equilibrium of all markets.

• Importance of Micro-economics:
1. Micro-economics is important to understand the working of a free enterprise
economy: In free enterprise there is no agency to plan and co-ordinate the working of the
economic system. Here, we cannot assure efficient working of the system. In this connection
Lerner has said—” Direct running of the economy is impossible because the modern economy
is so complex that no central planning body can obtain all the information and give out all the
directives necessary for its efficient operation.”
2. It provides an analytical tool for evaluating the economic policies of the state:
Price or market mechanism is the tool which helps us in this respect. There are certain public
utilities items like postal services, railways, water, electricity etc., which are run by government
which fixes prices on no profit no loss basis. This study helps the state government in
formulating correct price policies and in evaluating them in proper manner.
3. It is helpful to business executive: This study helps the business executive in the
attainment of maximum productivity with the resources available. Further, it helps in knowing
of consumer’s demand and in calculation of costs. 4. It is helpful in the efficient use of available
resources: This approach deals in economizing of scarce resources with efficiency. Proper
utilisation of available resources helps in achieving growth and stability.
5. It helps in understanding the various problems of taxation: It is the tax which
compels to the re-allocation of resources from their optimum. This analysis helps in the study
of distribution of incidence of a commodity tax (excise duty or sales tax) between sellers and
consumers.
6. It is helpful in international trade: In the field of international trade we can know and
understand as to how much there will be gain in international trade and balance of payments
and how foreign exchange rates are determined.
7. It is helpful in the construction and uses of simple methods for the
understanding of the actual economic phenomenon: In this connection R. A. Bilas
has said, “The theoretical approach to Microeconomics utilizes abstract models to see how
prices are established and how resources are allocated to various uses. The use of theory
should enable the processor to determine which of many facts are relevant to the problem
being studied.”
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

• Limitations/Dis-Utility/Dis-Advantages of Microeconomics
1. This analysis is unrealistic: It is based on unrealistic assumptions of full employment
in the economy. According to Keynes—” To assume full employment is not proper. Full
employment is not the rule but an exception in the real world. This study is unrealistic method
of economic analysis”. Ackley has said, “it is an elegant method of Solving Problem.”
2. It is the study of parts and neglects the whole: As Boulding has said—” It is the
study of imprecise picture of the economy
3. It is not only inadequate but misleading also in analysing several economic
problems: It is not essential that one principle can be applicable and used in the economy as
a whole.
4. Based on the assumption of Laissez-Faire: But the policy of Laissez Faire is no
longer followed and practiced. It has ended with the Great Depression of 1930. This study can
be said as unrealistic. To quote Boulding—” The character and behaviour of aggregate cannot
be obtained simply by generalizing from character and behaviour of the individual
components.”
Macro Economics
Meaning of Macro Economics:
Macro Economics is the study of “aggregates or averages covering the entire economy such as
total employment, toted unemployment, national income, national output, toted investment,
total consumption, total savings, aggregate supply, aggregate demand and general price-level,
wage-level, interest rates and cost structure.”
This analysis is also known as the “theory of income and employment” or “simply income
analysis”. It is concerned with the problems of unemployment, economic fluctuations, inflation,
deflation, instability and international trade and growth”.
Some economists have given the name of “Aggregative Economics”-which examines the
interrelations among the various aggregates, their determination and causes of fluctuations in
them.
Definition of Macro Economics:
According to Ackley: “Macro Economics deals with economic affairs in the large”, it
concerns the overall dimensions of economic life. It looks at the total size and shape of the
functioning rather than working of dimensions of the individual parts. Macro Economics is the
study of the causes of unemployment and the various determinants of employment.
• Importance of Macro-Economics:
Macro-Economic has got theoretical and practical importance. Its importance is as follows :
1. This analysis is indispensable for understanding the working of the economy:
Our main economic problems are related to the behaviour of total income, output, employment
and the general price-level in the economy. These are measurable and can help in analysing the
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

effects, on the functioning of the economy. As Tinbergen view is “that this concept helps in
making the elimination process understandable.”
2. This concept is extremely useful from the point of economic policy: In
underdeveloped economies the problems of over-population, inflation, balance of payments,
general under production etc. The main responsibilities of these governments are to control the
over-population, inflation, general price-level and volume of trade etc. In this connection
Tinbergen has said—” Working with macro-economic concepts is a bare necessity in order to
contribute solutions of the general problems of the time. No government can solve these
problems in terms of individual behaviour.”
(a) In General Unemployment: The Keynesian theory of employment has set the study
of macro-economics. Employment depends upon effective demand i.e., an aggregate demand
and aggregate supply function. Unemployment is caused by deficiency of effective demand.
Effective demand should be raised by increasing total investment, total output, total income and
total consumption. This economics has special importance in studying the causes effects and
remedies of general employment.
(b) In Economic Growth: The economics of growth is also a study of macro-economics.
Based on this economics the resources and capabilities of an economy are evaluated. Under this
the plans for the over-all increase in national income, output and employment is framed and
implemented, to raise the whole.
(c) In National Income: The study of macro-economics is helpful in the construction of
National Income Data. This National Income Data is helpful in forecasting the level of economic
activity and to understand the distribution of income among different groups of people.
(d) In dealing with Monetary Problems: As we are aware that inflation or deflation
affects the economy adversely. They can be solved by adopting monetary, fiscal and direct
control measures for the whole economy.
(e) In Understanding the Behaviour of Individual Units: Demand for individual
products depends upon aggregate demand in the economy. Unless the causes of deficiency in
aggregate demand are analysed, it is not possible to understand and decide fully the reason for
a fall in the demand of individual products.
(f) In Business Cycle: The importance of macro-economic lies in analysing the causes of
economic fluctuations and in giving proper remedies. By seeing the above facts, it can be said
that Macro-Economics throws much light on solving the problems of unemployment, inflation
economic instability and economic growth. As Ackley has said that “Macro-economics is more
than a specific method of analysis. It is also a body of “empirical economic knowledge.”
• Limitations of Macro-Economics:
1. This analysis is nothing but a fallacy of composition: In this analysis, these perhaps
have been forgotten that what is true of individuals is not necessarily true of the whole economy.
2. This analysis regards the aggregates as homogeneous without caring about
their internal composition and structure: The average wage in a country is the total of
wages in all occupations i.e., wages of clerks, teachers, nurses etc. But the aggregate
employment depends on the relative structure of wages rather than the average wage.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

3. The aggregate variables which form the economic system may not be of much significance
4. An indiscriminate use of this analysis in analysing the products may be misleading
5. The measurement of this analysis involves several conceptual difficulties.

• Distinction between Micro-Economics and Macro-Economics

Regarding the difference between Micro and Macro-Economic Ackley has written that “the
difference between micro and macro-economics is a difference of degree and not of kind, but
the degree is so great as to approach a difference of kind.” Other important differences are as
follows:
1. Use of Aggregates: The Micro-economics uses aggregates relating to individual
households, firms and industries, while Macro Economics uses aggregates which relate them to
the “economy wide total”.
2. Based on Study: Micro and Macro Economics are the study of aggregates. But the
aggregates in Micro-Economics are different from that in Macro Economics. In Micro-
Economics the inter-relationships of individual households, individual firms and individual
industries to each other deals with aggregation. Here, the concept of ‘industry’ means aggregate
of numerous firms or even products.
3. Based on Objective: The objective of Micro-economics on the demand side is to
maximise utility whereas on the supply side is to minimise profits at the minimum cost. On
the other hand, the main objectives of Macro Economics are full employment, price stability,
economic growth and favourable balance of payments.
4. Based on Origin: The word ‘Micro’ has been derived from the Greek word ‘mikros’
which means small. Micro-economics is the study of individuals and small groups of
individuals. It includes the study of households, particular firms, particular industries, particular
commodities and particular prices. The word ‘Macro’ has also been derived from the Greek
word ‘MAKROS’ which means large. It deals with aggregates of these quantities and not with
individual incomes and individual prices. It is the study of Total Output and National Output.
5. Basis of Difference: The basis of Micro-economics is the Price mechanism which
operates with the help of demand and supply forces. These forces help in the determination of
equilibrium prices in the market. On the other-hand, the basis of Macro Economic study is the
national income, output, employment and the general price-level which are determined by
aggregate demand and aggregate supply.
6. Based on Assumptions: Micro-economics is concerned with the rational behaviour of
individuals whereas the assumptions of Macro Economics are based on aggregate-volume of
the output of an economy and the size of the national income and general price-level.
7. Partial-Equilibrium and General Equilibrium: Microeconomics is based on the
partial equilibrium analysis which explains the equilibrium conditions of an individual, a firm
and an industry. On the other hand, Macro Economics is based on the general equilibrium
analysis which an elaborate and extensive study of several economic variables, their inter-
relations and interdependences of the working of the economic system.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Differences of Micro and Macro Economics

Basis of differences Micro economics Macro economics

The branch of economics that The branch of economics that
studies the behaviour of an studies the behaviour of the
Meaning individual consumer, firm, whole economy, (both
family is known as national and international) is
Microeconomics. known as Macroeconomics.
Deals with Individual economic Aggregate economic
variables variables
Business Application Applied to operational or Environment and external
internal issues issues
Tools Demand and Supply Aggregate Demand and
Aggregate Supply
It assumes that all macro- It assumes that all micro-
Assumption economic variables are economic variables are
constant. constant.
Theory of Product Pricing, Theory of National Income,
Theory of Factor Pricing, Aggregate Consumption,
Concerned with Theory of Economic Theory of General Price
Welfare. Level, Economic Growth.

Helpful in determining the Maintains stability in the

Importance prices of a product along with general price level and
the prices of factors of resolves the major problems
production (land, labour, of the economy like inflation,
capital, entrepreneur etc.) deflation, reflation,
within the economy. unemployment and poverty
as a whole.
It is based on unrealistic It has been analysed that
Limitations assumptions, i.e. In 'Fallacy of Composition'
microeconomics it is involves, which sometimes
assumed that there is a full doesn't prove true because it
employment in the society is possible that what is true
which is not at all possible. for aggregate may not be true
for individuals too
Covers various issues like Covers various issues like,
demand, supply, product national income, general
Scope pricing, factor pricing, price level, distribution,
production, consumption, employment, money etc
economic welfare, etc
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

• Difference between Economics and Managerial Economics:

Basis of
Economics Business Economics
Difference
It involves the framing of economic It involves the application of economic
Meaning
principles to solve economic problems. principles to solve economic problems.
It is microeconomic as well as
Character It is microeconomic in character.
macroeconomic in character.

In it, the fulfilment of the needs of

It involves proper decision-making as its
Main Task individuals, as well as entities, is the main
main task.
task.

It is positive as well as normative in

Nature It is only normative in nature.
nature.
It has a narrower scope as compared to the
Scope It has a wider scope.
scope of Economics.
It involves managerial economics as its
Branches It is an applied branch of economics.
applied branch.
It is concerned with all the theories
Concerned It is concerned with only profit theory and
starting from production to consumption
with ignores other theories.
including distribution.
It includes the analysis of macro-level
Analysis It includes the analysis of micro-level
issues like growth, inflation, and
Involved issues like demand, supply, and profit, etc.
employment, etc.
It concentrates on both economic as well as
It concentrates only on the economic
Concentration non-economic aspects of any business
aspects of any business problem.
problem.
Validity of In it, some assumptions become invalid
It is based on certain assumptions.
Assumptions when applied.

• Fundamental Principle of Managerial Economics

Introduction:
Managerial Economics is both conceptual and metrical. Before the substantive decision
problems which fall within the purview of managerial economics are discussed, it is useful to
identify and understand some of the basic concepts underlying the subject
Economic theory provides a number of concepts and analytical tools which can be of
considerable and immense help to a manager in taking many decisions and business planning.
This is not to say that economics has all the solutions. In fact, actual problem solving in business
has found that there exists a wide disparity between economic theory of the firm and actual
observed practice.
Therefore, it would be useful to examine the basic tools of managerial economics and the nature
and extent of gap between the economic theory of the firm and the managerial theory of the
firm. The contribution of economics to managerial economics lies in certain principles which
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

are basic to managerial economics. There are six basic principles of managerial economics.
They are:

1. The Incremental Concept

2. The Concept of Time Perspective
3. The Opportunity Cost Concept
4. The Discounting Concept
5. The Equi-marginal Concept
6. The Marginalism concept

1-The Incremental Concept:

The incremental concept is probably the most important concept in economics and is certainly
the most frequently used in Managerial Economics. Incremental concept is closely related to
the marginal cost and marginal revenues of economic theory.
The two major concepts in this analysis are incremental cost and incremental revenue.
Incremental cost denotes change in total cost, whereas incremental revenue means change in
total revenue resulting from a decision of the firm.
The incremental principle may be stated as follows:
A decision is clearly a profitable one if-

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.

Example:

Some businessmen hold the view that to make an overall profit, they must make a profit on
every job. The result is that they refuse orders that do not cover full costs plus a provision of
profit. This will lead to rejection of an order which prevents short run profit. A simple problem
will illustrate this point. Suppose a new order is estimated to bring in an additional revenue of
Rs. 10,000. The costs are estimated as under:

Labour Rs. 3,000

Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose
there is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to
overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already
on the pay roll will be deployed without added pay and no extra selling and administrative costs,
then the actual incremental cost is as follows:

Labour Rs. 2,000

Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Thus, there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental
reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices
which cover merely their incremental costs.
The concept is mainly used by the progressive concerns. Even though it is a widely followed
concept, it has certain limitations:
(a) The concept cannot be generalised because observed behaviour of the firm is always vari-
able.
(b) The concept can be applied only when there is excess capacity in the concern.
(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:

The time perspective concept states that the decision maker must give due consideration both
to the short run and long run effects of his decisions. He must give due emphasis to the various
time periods. It was Marshall who introduced time element in economic theory.
The economic concepts of the long run and the short run have become part of everyday
language. Managerial economists are also concerned with the short run and long run effects of
decisions on revenues as well as costs. The main problem in decision making is to establish the
right balance between long run and short run.
In the short period, the firm can change its output without changing its size. In the long period,
the firm can change its output by changing its size. In the short period, the output of the industry
is fixed because the firms cannot change their size of operation and they can vary only variable
factors. In the long period, the output of the industry is likely to be more because the firms have
enough time to increase their sizes and also use both variable and fixed factors.

In the short period, the average cost of a firm may be either more or less than its average revenue.
In the long period, the average cost of the firm will be equal to its average revenue. A decision
may be made on the basis of short run considerations, but may as time elapses have long run
repercussions which make it more or less profitable than it at first appeared.

Example: The firm which ignores the short run and long run considerations will meet with
failure can be explained with the help of the following illustration. Suppose, a firm having a
temporary idle capacity, received an order for 10,000 units of its product. The customer is
willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more. The short run
incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to
overhead and profit is Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm executes this
order, it will have to face the following repercussion in the long run:

(a) It may not be able to take up business with higher contributions in the long run.
(b) The other customers may also demand a similar low price.
(c) The image of the firm may be spoilt in the business community.
(d) The long run effects of pricing below full cost may be more than offset any short run gain.

Haynes, Mote and Paul refer to the example of a printing company which never quotes prices
below full cost due to the following reasons:

(1) The management realized that the long run repercussions of pricing below full cost would
more than offset any short run gain.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

(2) Reduction in rates for some customers will bring undesirable effect on customer goodwill.
Therefore, the managerial economist should take into account both the short run and long run
effects as revenues and costs, giving appropriate weight to most relevant time periods.

3. The Opportunity Cost Concept:

Both micro and macroeconomics make abundant use of the fundamental concept of opportunity
cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate
its significance. In Managerial Economics, the opportunity cost concept is useful in decision
involving a choice between different alternative courses of action. Resources are scarce, we
cannot produce all the commodities. For the production of one commodity, we have to forego
the production of another commodity. We cannot have everything we want. We are, therefore,
forced to make a choice.
Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice
of alternatives is involved when carrying out a decision requires using a resource that is limited
in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone
by pursuing one course of action rather than another
the concept of opportunity cost implies three things:

1. The calculation of opportunity cost involves the measurement of sacrifices.

2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost is just a notional idea which does not appear in the books of account of the
company. If resource has no alternative use, then its opportunity cost is nil.
In managerial decision making, the concept of opportunity cost occupies an important place.
The economic significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods.

2. It helps in determining normal remuneration to a factor of production.
3. It helps in proper allocation of factor resources.

4. Equi-Marginal Concept:
One of the widest known principles of economics is the equi-marginal principle. The principle
states that an input should be allocated so that value added by the last unit is the same in all
cases. This generalisation is popularly called the equi-marginal.
Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is
involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities
by employing more labour but only at the cost i.e., sacrifice of other activities.
An optimum allocation cannot be achieved if the value of the marginal product is greater in one
activity than in another. It would be, therefore, profitable to shift labour from low marginal
value activity to high marginal value activity, thus increasing the total value of all products
taken together.
If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in
activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity
B. The optimum is reached when the values of the marginal product is equal to all activities.
This can be expressed symbolically as follows:
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities i.e., the value of the marginal product of labour employed in A is equal to
the value of the marginal product of the labour employed in В and so on. The equi-marginal
principle is an extremely practical notion. It is behind any rational budgetary procedure. The
principle is also applied in investment decisions and allocation of research expenditures. For a
consumer, this concept implies that money may be allocated over various commodities such
that marginal utility derived from the use of each commodity is the same. Similarly, for a
producer this concept implies that resources be allocated in such a manner that the marginal
product of the inputs is the same in all uses.

5. Discounting Concept:
This concept is an extension of the concept of time perspective. Since future is unknown and
incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is
worth more than a rupee will be two years from now. This appears similar to the saying that “a
bird in hand is more worth than two in the bush.” This judgment is made not on account of the
uncertainty surrounding the future or the risk of inflation.
It is simply that in the intervening period a sum of money can earn a return which is ruled out
if the same sum is available only at the end of the period. In technical parlance, it is said that
the present value of one rupee available at the end of two years is the present value of one rupee
available today. The mathematical technique for adjusting for the time value of money and
computing present value is called ‘discounting’.
The following example would make this point clear. Suppose, you are offered a choice of Rs.
1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true
because future is uncertain. Let us assume you can earn 10 per cent interest during a year.You
may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year i.e., Rs.
1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any
investment which will yield a return over a period of time, it is advisable to find out its ‘net
present worth’. Unless these returns are discounted and the present value of returns calculated,
it is not possible to judge whether or not the cost of undertaking the investment today is worth.

The concept of discounting is found most useful in managerial economics in decision problems
pertaining to investment planning or capital budgeting.

The formula of computing the present value is given below:

V = A/1+i
where:
V = Present value
A = Amount invested Rs. 100
i = Rate of interest 5 per cent
V = 100/1+.05 = 100/1.05 =Rs. 95.24
Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years
V = A/ (1+i) 2
For n years V = A/ (1+i) n
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

6-Marginalism Principle:

Marginal analysis implies judging the impact of a unit change in one variable on the other.
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 refers 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. Marginalism is the economic principle that
economic decisions are made and economic behaviour occurs in terms of incremental units,
rather than categorically. The key focus of marginalism is that asking how much, more or less,
of an activity (production, consumption, buying, selling, etc.)
Marginalism is a theory that asserts individuals make decisions on the purchase of an additional
unit of a good or service based on the additional utility they will receive from it. Marginalism
theory helps to better explain human rationality, human action, subjective valuation, and
efficient market prices for example, a person wishing to reduce a bad habit, such as problem
drinking, may focus on not drinking for one additional day, rather than on a one-time, life-
changing decision
UTILITY ANALYSIS

Meaning and definition of Utility Analysis:

The term utility in Economics is used to denote that quality in a good or service by which our
wants are satisfied. In, other words utility is defined as the want satisfying power of a
commodity.
Definitions:

According to Mrs. Robinson,

“Utility is the quality of commodities that makes individuals want to buy them.”
According to Hibdon,
“Utility is the quality of a good to satisfy a want.”

• According to Jevons, “Utility refers to abstract quality whereby an object serves our
purpose.
• In the words of Hibdon, “Utility is the quality of good to satisfy a want.”
• According to Mrs. Robinson, “Utility is the quality in commodities that makes
individuals wants to buy them”

Features of Utility Analysis:

The utility analysis has the following main features;

1. Subjective.
2. Relative.
3. Usefulness, and.
4. Morality.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

1-The utility is Subjective:

The utility is subjective because it deals with the mental satisfaction of a man. A commodity
may have different utility for different persons. Cigarette has utility for a smoker but for a
person who does not smoke, the cigarette has no utility. Utility, therefore, is subjective.

2-The utility is Relative:

The utility of a good never remains the same. It varies with time and place. The fan has utility
in the summer but not during the winter season.

3-Utility and usefulness:

A commodity having utility need not be useful. Cigarette and liquor are harmful to health, but
if they satisfy the want of an addict then they have utility for him.

4-Utility and Morality:

The utility is independent of morality. Use of liquor or opium may not be proper from the moral
point of views. But as these intoxicants satisfy wants of the drunkards and opium eaters, they
have utility for them.
5-Utility is not essentially Useful: A commodity having utility need not be useful. E.g. Liquor
and cigarette are not useful, but if these things satisfy the want of addict then they have utility
for him

Can utility be measured?

It can be attempted to measure by two methods:

1.cardinal utility. 2. ordinal utility.

The measurement of utility has always been a controversial issue. Neo-classical economists,
such as Alfred Marshall, Leon Walrus, and Carl Manager believed that utility is cardinal or
quantitative like other mathematical variables, such as height, weight, velocity, air pressure, and
temperature.
Therefore, these economists developed cardinal utility concept to measure the utility derived
from a good. They developed a unit of measuring utility, which is known as utils. For example,
according to the cardinal utility concept, an individual gains 20 utils from ice-cream and 10 utils
from coffee.
However, modern economists, such as J.R. Hicks, gave the concept of ordinal utility of
measuring utility. According to this concept, utility cannot be measured numerically, it can only
be ranked as 1, 2, 3, and so on. For instance, an individual prefers ice-cream than coffee, which
implies that utility of ice-cream is given rank 1 and coffee as rank 2.

1- Cardinal Utility Concept:

The neo-classical economists propounded the theory of consumption (consumer behaviour
theory) on the assumption that utility is cardinal. For measuring utility, a term ‘util’ is coined
which means units of utility.
Cardinal Utility explains that the satisfaction level after consuming a good or service can be
scaled in terms of countable numbers.
The cardinal utility theory or approach was proposed by classical economists, Gossen
(Germany), William Stanley Jevons (England), Leon Walras (France), and Karl Menger
(Austria).
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Later on, a neo-classical economist, Alfred Marshall brought about significant refinement
in the cardinal utility theory. Therefore, cardinal utility theory is also known as neo-classical
utility theory.

Neo-classical economists believed that utility is cardinal or quantitative like other

mathematical variables, such as height, weight, velocity, air pressure, and temperature.
They developed a unit of measuring utility called utils.

For example, according to the cardinal utility concept, an individual gains 20 utils from a
pizza and 10 utils from coffee. In the measurement of utility, neo-classicists assumed that
one util equals one unit of money and the utility of money remains constant.

On the indifference curve (IC), there can be several other points in between the points a, b, c,
d, and e, which would yield the same level of satisfaction to the consumer. Therefore, the
consumer remains indifferent towards any combinations of two substitutes yielding the
same level of satisfaction.

Assumptions of the cardinal utility concept

The assumptions of the cardinal utility approach are as follows:

1. Utility is measurable
2. Marginal utility of money is constant
3. Utilities are additive

1-Utility is measurable
The basic assumption of the cardinal utility approach is that utilities of commodities can be
quantified. According to Marshall, money is used to measure the utilities of commodities.
This implies that the amount of money that a customer is willing to pay for a particular
commodity is a measure of its utility.

2-Marginal utility of money is constant

The cardinal utility approach assumes that money must measure the same amount of utility
under all circumstances. To put simply, the utility derived from each unit of money remains
constant.

3-Utilities are additive

As per this assumption, the utility derived from various commodities consumed by an
individual can be added together to derive the total utility. Suppose an individual consumes
X1, X2, X3,….Xn units of commodity X and derives U1, U2, U3,….Un until respectively, the total
utility that the individual derives from n units of the commodity can be expressed as
follows:
Un = U1(X1) + U2(X2) + … + Un (Xn)

• Diminishing marginal utility: The marginal utility of a commodity diminishes as

an individual consumes successive units of a commodity. This can be expressed as
follows: MUX = f(Qx)
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

• Where MUX is the marginal utility of commodity X, f is a function, and Qx is the

quantity of the commodity consumed.

• Rationality: Consumers are rational beings and aim to maximize their utility at the
given income level and market price.

• According to the cardinal utility approach, a consumer reaches his equilibrium when
the last unit of his money spent on each unit of the commodity yield the same utility.
Therefore, the consumer would spend his/her money income on commodity X so long
as:

• MUx > Px (MUm)

• Where Px is the price of the commodity, MUx is the marginal utility of the commodity
and MUm is the marginal utility of money.
• A utility maximising consumer reaches the equilibrium when:

• MUx = Px (MUm) or = 1
• This equilibrium condition derives the consumer demand curve for commodity X,
which is shown in Figure.

The line parallel to the X-axis, Px (MUm) depicts the constant utility of money weighed by the
price of commodity X. MUx curve represents the diminishing marginal utility of commodity X.
Both the lines intersect at point E, which means the consumer reaches equilibrium at point E.

2. Ordinal Utility Concept:

Ordinal Utility explains that the satisfaction after consuming a good or service cannot be
scaled in numbers, however, these things can be arranged in the order of preference. In the
1930s, two English economists, John Hicks and R.J. Allen argued that the theory of consumer
behaviour should be developed on the basis of ordinal utility
According to the ordinal theory, utility is a psychological phenomenon like happiness,
satisfaction, etc. It is highly subjective in nature and varies across individuals. Therefore, it
cannot be measured in quantifiable terms.
As per the ordinal utility approach, utility can be measured in relative terms such as less than
and greater than. The approach advocates that consumer behaviour can be explained in terms
of preferences or rankings.
For example, a consumer may prefer ice-cream over soft drink. In such a case, ice-cream
would have 1st rank, while 2nd rank would be given to soft drink.
Therefore, as per the ordinal utility approach, a consumer identifies several pairs of two
commodities which would provide him/her the same level of satisfaction. Among these pairs,
he may prefer one commodity over the other based on how he/she ranks them in order of
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

utility. This implies that utility can be ranked qualitatively and not quantitatively. To better
understand the ordinal utility approach, there are certain concepts that need to be discussed.
Cardinal utility approach is based on the fact that the exact or absolute measurement of utility
is not possible. However, modern economists rejected the cardinal utility approach and
introduced the concept of ordinal utility for the analysis of consumer behaviour.
According to them, it may not be possible to measure exact utility, but it can be expressed in
terms of less or more useful good. For instance, a consumer consumes coconut oil and
mustard oil. In such a case, the consumer cannot say that coconut oil gives 10 utils and
mustard oil gives 20 utils. Instead, he/she can say that mustard oil gives more utility to
him/her than coconut oil. In such a case, mustard oil would be given rank 1 and coconut oil
would be given rank 2 by the consumer. This assumption lays the foundation for the ordinal
theory of consumer behaviour.
According to neo-classical economists, cardinal measurement of utility is possible in practical
situations. Moreover, they believed that the concept of cardinal utility is useful in analysing
consumer behaviour. However, modern economists believed that utility is related to
psychological aspect of consumers; therefore, it cannot be measured in quantitative terms.

Assumptions of Ordinal Utility

The ordinal utility approach is based on certain assumptions, which are as follows:

1. Rationality
2. Ordinal utility
3. Transitivity and uniformity of choice
4. Non-satiety
5. Diminishing marginal rate of substitution

1-Rationality
Consumers are rational beings and aim to maximise their utility at the given income level and
market price of commodities that they consume.

2-Ordinal utility
Utility cannot be measured in quantitative terms but in qualitative terms. This is because a
consumer expresses his/ her preference for a commodity out of a collection of similar goods.

3-Transitivity and uniformity of choice

It is assumed that a consumer’s choice is always transitive. This implies that if a consumer
prefers A to B and B to C, the consumer would prefer A to C as well. On the other hand, if the
consumer considers A=B and B=C, he must consider A=C. On the other hand, uniformity of
choice implies that if a consumer prefers A to B at one time period, he/ she does not prefer B to
A in another time period or even does not consider A and B as equal.

4-non-satiety
The theory also assumes that a consumer is never oversupplied with commodities. This
means that a consumer does not reach a state of saturation in case of any commodity. Thus,
a consumer tends to prefer larger quantities of a commodity over smaller.
 Mrs. Nisha Pandey Assistant Professor (Managerial Economics)

Difference between Cardinal and Ordinal Utility

Approaches Cardinal Utility Ordinal Utility

Realistic Less More
Measurement Utility Rank
Analysis Marginal Utility Analysis Indifference Curve Analysis
Promoted By Classical and Neo-classical Modern Economists
Economists