Fundamentals concepts of Economics or Basic Economic Concepts There are six major fundamental economic concepts which are
used explicitly or implicitly, consciously or unconsciously, deliberately or otherwise in business decisions. They are: 1. Opportunity Cost and Decision Rule: the concept of opportunity cost is related to the alternative uses of scarce resources. Resources either natural or manmade are scarce. They are scarce in relation to demand for them to satisfy the ever growing human needs. Resources though scarce, have alternative uses. The scarcity and alternative uses of the resources give rise to the concept of opportunity cost. Thus, it refers to sacrificing the next best alternative in order to attain the first best alternative. The above explanation can be supported by the following example: a. If a firm has Rs.100 million at its disposal and the firm finds 3 risk-free alternative uses of fund available to it. They are: i. Expansion of the size of the firm Rs.20milloin ii. Setting up a new production unit Rs.18million iii. Buying shares in another firm Rs.16million b. All the other things being the same the rational decision for the firm would be to invest in the first alternative. This implies that the manager would have to sacrifice the annual return of Rs.18million from the 2nd best alternative. Rs 18millionis called an annual opportunity cost of an annual income of Rs.20million. c. The difference between actual earning and its opportunity cost is called economic gain or economic profit. 2. Marginal Principle and Decision Rule: The concept of marginal value is widely used in economic analysis like consumer analysis, marginal cost in production analysis and marginal revenue in pricing theory. The term marginal refers to change (increase or decrease) in total quantity or value due to one unit change in its determinant. This is mainly utilized when the problem is associated with maximization or minimization of a firm’s profit, etc. for example: a. The total cost of production of a commodity depends on the number of units produced, for a given factor prices. In this case, marginal cost, MC can be defined as the change in the total cost as a result of producing one additional unit of a commodity. Thus, MC can be worked out as
Marginal cost, MC= TCn - TCn-1
Where, TCn=total cost of producing n units and
TCn-1=total cost of producing n-1 units.
Alternatively, marginal revenue depends on the total number of units at some point of time. So MR can be defined as the change
they are i. 115million. TRn=total revenue from the sale of n units TRn-1=total revenue from sale the sale of n-1 units. if a firm decides to increase production by adding a new plant to the existing capacity. Then.
Marginal Revenue= TR n-TRn-1
Where. buildings. Such an increase in total cost and total revenue is called incremental cost and incremental revenue respectively related to incremental output. In simple words. Present explicit costs: consists both fixed and variable costs ii. IC involves both fixed and variable cost. the profit of a firm is maximized at that level of output where the cost of producing one additional unit equals the revenue from the sale of that unit of output. business managers use the incremental principles in their business decisions. The necessary condition for profit maximizing output is that MC must be equal to MR.e. with a difference. Decision Rule: The question before any firm is how much to produce so as to maximize the profit? The quantity produced should be such that MR>MC. ships. For example. large. 3. turbines etc. i. Therefore. a. profit is maximum when MR=MC. But these values obtained are different when compared to the value when taken in units instead of functions. Opportunity costs: refers to expected income in foregone from the next best use of the resources involved in the present decision.in TR due to the sale of one additional unit of product. There are three major components in IC. Marginal principle can be applied only where MC & MR can be calculated precisely. If TC and TR are given in the form of a function then MC and MR can be obtained by taking the first derivative of TC and TR. difference between 100million & 115million is called as incremental cost. Rs100million to Rs.
. Incremental Principle and Decision Rule: It is similar to the concept of marginal value but. but it is difficult to estimate MC & MR for the firms as mostly business firms produce and sell their products in bulk and not in terms of units unless it is the case of production and sale of such large unit goods as airplanes. MC involves only variable cost. then this increases the firms total cost of production from say. The incremental principle is applied to business decisions which involve bulk production and a large increase in total cost and total revenue. b. where production and sale activities are carried out on bulk basis and where both fixed & variable costs are subject to change.
e. Direct material costs iii. It is important to know what is included and what is not included in the incremental cost and incremental revenue. ii. Sunk costs: the costs which have already been made on purchase of assets and non-recoverable advance payments. Whether or not to introduce a new product c. New additional equipment ii. Future costs: include depreciation and advertising costs if the product does not sell as well as expected c. The law of equimarginal utility principle was over time applied by business managers to allocation of resources between their alternative uses with a view to maximizing the profit in case of a firm carries out more than one business activity. all current expenses. The i. New additional personnel Opportunity costs Future incremental costs
ii. it is important to know what the incremental cost is and what the relevant incremental revenue is. Whether or not to accept a project b. Direct labor costs ii. Fixed costs i. 5. Whether or not to add an additional plant e. For the use of contribution analysis for a business decision.t any business decision. Whether or not to accept a fresh order d. It is a useful technique for taking decisions on: a. Present explicit costs: i. On the other hand incremental revenue is the increase in the total revenue resulting from a business decision.iii. The Equi-Marginal Principle: This principle was originally associated with consumption theory and the law is called “law of equimarginal utility”. a. Explicit variable costs include: i. 4. iii. Contribution Analysis and Decision Rule: This concept is associated with the concept of incremental cost and incremental revenue.
. The relevant IC’s that are taken into account in the contribution analysis include the following: i.r. Whether to make or buy etc. Contribution of a business decision can be defined as a difference between the incremental revenue and the incremental cost associated with that particular decision.
Irrelevant costs are: Committed costs: which have already been committed by a firm and which cannot be changed w. Direct variable overheads b.
. advertisement. All business decisions may not have same perspective. expansion of the scale of production. 3… indicate the order of the unit of expenditure on Projects A. that is Rs. & C. Time Perspective In Business Decision: A business decisions are taken with a certain time perspective. bribing a government officer and investment abroad. a firm has a 100millon capital and can allocate them in the following ways: Units of Expenditure (Rs. For example.40million on project A and Rs. 30million each on projects B and C. spending on labor welfare activities. 2. The time perspective refers to the duration of time period extending from the relevant past and foreseeable future taken in view while taking a business decision.e. investment in plant.10million) First Second Third Fourth Fifth Marginal productivity(MP) Project A 501 452 357 2010 10 Project B 403 305 208 10 0 Project C 354 306 209 15 12
Where 1. Example: manufacturing of Diwali crackers. land. it is the period of past experience and trends which are relevant for business decisions with long run implications.. B. building.principle suggests that available resources (i/p’s) should be so allocated between the alternative options that the marginal productivity gains from the various activities are equalized. some have short run outcome or pay-off and therefore involve short run perspective. No other pattern of investment will ensure this objective. There are some other decisions which have long run implication i. The equimarginal principle now suggests that a profit (gain) maximizing firm allocates its resources in a proportion such that
MPA=MPB=MPC=…. this pattern of investment maximizes the firms productivity gains. 6. introduction of new product. The business decision makers must assess and determine the perspective of business propositions well in advance and make decisions accordingly. machinery. Relevant past means. Suppose a firm has a total capital of 100million with it and it wants to allocate the capital b/w 3 alternatives.=MPn
Always the change should be the same for all the projects. The firm has used four units of finance for project A. and three units each projects B & C.
There are some other decisions which have long run implication i.e. machinery. The time perspective refers to the duration of time period extending from the relevant past and foreseeable future taken in view while taking a business decision. bribing a government officer and investment abroad.Always the change should be the same for all the projects. Relevant past means. investment in plant. Example: manufacturing of Diwali crackers. 6.
. land. Time Perspective In Business Decision: A business decisions are taken with a certain time perspective. The business decision makers must assess and determine the perspective of business propositions well in advance and make decisions accordingly. it is the period of past experience and trends which are relevant for business decisions with long run implications. advertisement. All business decisions may not have same perspective. some have short run outcome or pay-off and therefore involve short run perspective. introduction of new product. expansion of the scale of production. building. spending on labor welfare activities.