Integrated MBA -5 Years Program

(School Of Management Studies)

Year-1
Semester-1
Subject Name: Fundamentals of Managerial Economics
Subject Code: 5016104
Dr. Richa Mandan

Module 1-Added Concepts: Concept of Economics in Decision Making: Differadbetween

Microeconomics and Macroeconomics; Circular flow of income and
expenditure
"Produetion Possibility Frontier"?; Role of assumptions in economics

Concept of Economics in Decision Making

As we had discussed various aspects of economics- scarcity and effcieney and meaning and role of
managerial economics. Now we will be discussing the variouspecof decision making

What do you mean by Decision Making?

Well decision making is not something which is refated to managers only or which is related to
corporate world, but it is something which is d to everybody's life. Whether a person is
working or non working, irrespective of his/heeld,decision making is important to everyone. You
need to make decision irrespective of theonyou are doing. As a student also you have to take so
many decisions. Suppose at a particular pout of time you want to go for a movie, and at the same
point of you want to go for shopping then what you will do. You can't do two things at the same
point of time. You have to decidewhat to do first and what to do next. Therefore decision making
can be called as choosing the right option from the given one. To decide is to choose. Whether to do
this or to do that is what is decision making.

Decision making is the rost important function of business managers. Decision making is the central
objective of Manasana Economics. Decision making may be defined as the process of selecting the
suitable actim fronamong several alternative courses of action. The problem of decision making
arises whencera number of altematives are available. Such as:

What should be the price of the product?

What should be the size of the plant to be installed?
How many workers should be employed?
What kind of training should be imparted to them?
What is the optimal level of inventories of finished products, raw material, spare
parts, etc.2
Therefore we can say that the problem of decision making arises due to the scarcity of resources. We
have unlimited wants and the means to satisfy those wants are limited, with the satisfaction of one
want, another arises, and here arises the problem of decision making. While performing his function
manager has to take a lot of decisions in conformity with the goal of the firm. Most of the decisions
are taken under the condition of uncertainty, and involves risks.

The main reasons behind uncertainty and risks are uncertain behavior of the market forces which are
as follows:

1. The demand and supply

2. Changing business environment
3. Government policies
4. External influence on the domestic market
gram
5. Social and political changes
6. The maximum use of limited resources.

Managerlal Economies s a Tool for Improving Management Declslon Maklng

Managerial economics uses economic concepts and quantitative methods to solve managerial problems.

Management Decision Problems

Product Selection, Output, and Pricing
Internet Strategy
Organization Design and Promotion
Product Development
Strategy
Worker Hiring and Training
Investment and Financing

Economic Concepts Quantitative Methods

Marginal Analysis Numerical Analysis
Theory of Consumer Demand Statistical Estimation
Theory of the Firm Forecasting Procedures
Industrial Organization and Firm Game Theory Concepts
Behavior Optimization Techniques
Public Choice Theory Information Systems

Managerial Economics
Use of Economic Concepts and
Quantitative Methods to Solve
Management Decision Problems

Optimal Solutions to Management

Decision Problems

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Differentiate between Microeconomics and Macroeconomics

Microeconomics:
1. It is the study of individual economic unitsof an economy.
2. It deals with Individual Income, Individual prices, Individual output, etc.
3. Its central problem is price determination and allocation
ofresources.
4. Its main tools are demand and supply of a particular commodity/factor.
5. It helps to solve the central problem of 'what, how and for whom' to pro duce. In the
economy
6. It discusses how equilibrium of a consumer, a producer or an Industry Is attained. Price is the
main determinant of micro- economic problems.
7. Examples are: Individual Income, Individual savings, price determination ofacommodity
individual fírm's output, consumer's equilibrium.
Macroeconomics:
Qgr
1. Itis the study ofeconomy as a whole and its ageregates.
2. It deals with aggregates like national Income, general price leydl tional output, etc.
3. Its central problem is determination of level of Income and employment.
4. Its main tools are aggregate demand and aggregate suppiof the economy as a whole.
5. It helps to solve the central problem of full employment of resources in the economy.
6. It is concemed with the determination of equilibfiulevel of Income and employment of the
economy.
7. Income is the major determinant of maeToeconomic problems.
8. Examples are: National Incomenaionalsavings,general price level, aggregate demand,
aggregate supply, poverty.ynemployment, etc.

CIRCULAR FLOWS OF INCOMEAND EXPENDITURE INA TWO-SECTOR MODEL

Two-sector model consists of oply household and firm sectors represents a private closed economy in
which there is no govermmepfand no foreign trade. A two-sector model is obviously and unrealistic
model. However, to begin with a two-sector economy provides a convenient starting point to analyze
the circular flows.
Before we analyze the circular flows, it is important know the basic features and functions of
the household and the firms.
The household are assumed to possess certain specific features: (1) the household are the
ownersotalfators of produetion; (i) their total income consists of wages, rent, interest and (ii)
theyre the cónsumer of all consumer goods and services.
The business firms, on the other hand, are assumed to have the following features and
functions: (i) they own no resources of their own, (ii) they hire and use the factors of production from
the households, (ii) they produce and sell goods and services to the household: and (iv) they do not
save, that is, there is no corporate saving.
Having specified the model, we now describe and illustrate the circular flows of income and
expenditure in two-sector model.

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 The Circular Flows in a Two-Sector Economy:
A Graphic Presentation
The working of a two-sector economy and the circular flows of incomes and expenditure are
illustrated in the below given figure. The households are represented by the rectangle labeled
Household' and the business sector by the rectangle labeled "Firms, with respective characteristics.
A line drawn from the Household' to the 'Firms' divides the diagram into two parts-the upper half
and the lower half. The upper half represents the factor market and the lower half represents the
commodity or product market. Both the markets generate two kinds of flows-goods flow and
money flow. The goods flow is also called, real-flow. (We will use the terms goods flow and 'real
flow' interchangeably). Let us first look at the goods and money flows in the factor market
In the factor market (the upper half), the arrow labeled 'Factor Services' showsthe fow of
factor of production (FOP) from he households to the firms. This makes the good or feal flow
shown by a continuous arrow. The goods or factor flow causes another and a reverseow, that is, the
flow of factor incomes (wages, interest, rent and profits) from the firms the fim to thé households.
Since all factor payments (PF) are made in money, the flow of factor incomes rpresents the money
flow. The money flow, shown by the arrow from fims to households, comprises the total income (Y)
of the households. Note that factor services and money flow in the opposite direétion.
Let us now look at the commodity market (the lower half of the diagram) as shown in the
diagram, the goods and services produced by the firms flow from the households. The payment made
by the households for the goods and services creates money flow. Note again that real (goods) and
money flows in the commodity market too go in opposite direction.
When we combine the goods and money flows in the factor and goods markets and look at
the flows in continuity, we find a circularly in the flows. Bcombining the continuous arrows in the
goods an factor markets, we get the circular flow of goods. By the same process, we get the circular
flow of money. As Fig. 2.1 shows, the real flow shown by the dashed arrow moves anti-clockwise.
Clearly, goods and money flow in the opposite
direction.
yEFP
FPW+T+I+p
W+r+I+p =V
V =Y

FACTOR MARKET
FACTOR PAYMENTS
( R e n t ,W a g e s Interest Profits)
Where, Y household income, FP = factor
payments, w = wages, r = rent, I = interest,
FACTOR SERVIcEs P profits, and V = value of output.
Land,Labour,
Labour. Cap
Capital and En nd Enterprise)
In the final analysis, household income=
Firm or
Household o factor payments = the money value of
Producing Consumer
Sector Sector output. That is
Y = FP = V
This identity is important for national
GOODS&SERvICESODS&SERVC
CONSUMONPTIoN EXPENDTURE
E O n come d mination

PRODUCT MARKET
Diagram shouing real flous (inner arrous) and money Jlous (ouler arrous)
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Role of Assumptions in Economics
Assumptions are statements that we universally accept as a fact without questioning their validity.
And we take them to be true under any circumstance or situation. However, these assumptions can be
wrong sometimes, or there may be outliers in any situation. But we still take them at their face value
and consider them to be right in the majority of the situations. Therefore, "Why do Economists make
assumptions?" is a genuine question because there is a chance that they are wrong too. Now let us
look into this question more deeply and try to find the answer.
However, it may be noted that in all the streams of knowledge and models where human beings are
involved, we have to keep certain assumptions to propagate any model, theory, or cause and effect
relationship, etc.

1. Assumptions provide a basis for theory-formulation, on the basis of which economists create
laws and models.
2. They tend to simplify the process by giving a readymade base that is universally acceptable
and easy to understand.
3. They help to break down complex data into pieces that help individuals in problem-solving
and application.
4. They are generally tested to be true for the majority of people in any given sample. Therefore,
the chance of a theory going wrong by relying on these assumptions is very rare.

What is 'Production Possibility Frontier"

Definition: Production possibility frontier is the graph which indicates the various production
possibilities of two commodities when resources are fixed. The production of one commodity can
only be increased by sacrificing the production of the other commodity. It is also called the
production possibility curve or product transformation curve. The factors that are included in the
input are natural resources, capital goods, labour and entrepreneurship.

The production of one good can be increased when the production of the other good is sacrificed.
The Production Possibility Frontier (PPF) is also known as the Production Possibility Curve.
The production possibility frontier represents the concepts of scarcity, tradeoffs and choice and the
shape of the curve will change based on whether the price costs are constant, increasing or
decreasing
The slope of the PPF is indicative of the opportunity cost of producing a good in comparison to
another good. The same can be used for comparing the opportunity costs of another producer for
determining the comparative advantage.

Description: The state of technology is taken to be constant. Since the production of one commodity
can be increased only by decreasing the production of the other commodity, production possibility
curve also measures the production efficiency of the commodities. The production possibility frontier
helps in deciding the commodities most beneficial to society, but this response is limited in itself as
there is a choice between two commodities only. In other words it also helps in letting the businesses

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understand how much quantity of good must be given up in order to make space for producing
another type of good.

Interpreting the PPE Curve

The shape of the PPF curve is like a bow in an outward position. The highest point on the graph will
be when a good is produced on the y-axis and the second good is not produced at all on the x-axis.

The widest part of the curve will be represented by the point where no good is produced on y-axis
whereas maximum production is happening on the x-axis.

All other points in the graph are regarded as tradeoff points, which means both the goods are
produced in varying degrees in these points.

The points on the PPF curve are said to be efficient and indicates that the resources of the economy
are utilised fully. This is known as the Pareto Efficiency, which refers to the idea that an economy is
operating at its full potential and there is no possibility of getting more output from the available
resources.

The points inside a PPF curve are known as inefficient points as the output from these points could
be greater than the economy's current resources. Conversely, the points outside the PPF curve

earS
ears
represents production of two goods at its maximum level, which is not possible due to limited or
fixed resources.

Quantity of butter produced

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