LECTURE NOTES

ON
MANAGERIAL ECONOMICS
UNIT – I
MBA I SEMESTER

Ms. Jyo Gaur

Assistant Professor
INTRODUCTION TO MANAGERIAL ECONOMICS
Imagine for a while that you have finished your studies and have joined as an engineer in a
manufacturing organiza on. What do you do there? You plan to produce maximum quan ty
of goods of a given quality at a reasonable cost. On the other hand, if you are a sale manager,
you have to sell a maximum amount of goods with minimum adver sement costs. In other
words, you want to minimize your costs and maximize your returns and by doing so, you are
prac cing the principles of managerial economics.
Managers, in their day-to-day ac vi es, are always confronted with several issues such as how
much quan ty is to be supplied; at what price; should the product be made internally; or
whether it should be bought from outside; how much quan ty is to be produced to make a
given amount of profit and so on. Managerial economics provides us a basic insight into
seeking solu ons for managerial problems. Managerial economics, as the name itself implies,
is an offshoot of two dis nct disciplines:
Economics and Management.
In other words, it is necessary to understand what these disciplines are, at least in brief,to
understand the nature and scope of managerial economics.
INTRODUCTION TO ECONOMICS:
Economics is a study of human ac vity both at individual and na onal level. The economists
of early age treated economics merely as the science of wealth. The reason for this is clear.
Every one of us in involved in efforts aimed at earning money and spending this money to
sa sfy our wants such as food, Clothing, shelter, and others. Such ac vi es of earning and
spending money are called―Economic ac vi es.
It was only during the eighteenth century that Adam Smith, the Father of Economics, defined
economics as the study of nature and uses of na onal wealth‘.
Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes
Economics is a study of man‘s ac ons in the ordinary business of life: it enquires how he gets
his income and how he uses it. Thus, it is one side, a study of wealth; and on the other, and
more important side; it is the study of man. As Marshall observed, the chief aim of economics
is to promote human welfare‘, but not wealth. The defini on given by AC Pigou endorses the
opinion of Marshall. Pigou defines Economics as ―the study of economic welfare that can be
brought directly and indirectly, into rela onship with the measuring rod of money.
Prof. Lionel Robbins defined Economics as ―the science, which studies human behaviour as a
rela onship between ends and scarce means which have alterna ve uses‖. With this, the
focus of economics shi ed from ‗wealth‘ to human behaviour‘.
Lord Keynes defined economics as ‗the study of the administra on of scarce means and the
determinants of employments and income.
MICROECONOMICS
The study of an individual consumer or a firm is called microeconomics (also called the Theory
of Firm). Micro means ‘Small‘. Microeconomics deals with behaviour and problems of single
individual and of micro organiza on. Managerial economics has its roots in microeconomics
and it deals with the micro or individual enterprises. It is concerned with the applica on of
the concepts such as price theory, Law of Demand and theories of market structure and so
on.
MACROECONOMICS
The study of aggregate ‘or total level of economic ac vity in a country is called
macroeconomics. It studies the flow of economics resources or factors of produc on (such as
land, labour, capital, organiza on and technology) from the resource owner to the business
firms and then from the business firms to the households. It deals with total aggregates, for
instance, total na onal income total employment, output and total investment.
It studies the interrela ons among various aggregates and examines their nature and
behaviour, their determina on and causes of fluctua ons in the. It deals with the price level
in general, instead of studying the prices of individual commodi es. It is concerned with the
level of employment in the economy. It discusses aggregate consump on, aggregate
investment, price level, and payment, theories of employment, and so on.
Though macroeconomics provides the necessary framework in term of government policies
etc., for the firm to act upon dealing with analysis of business condi ons, it has less direct
relevance in the study of theory of firm.
MEANING AND NATURE:
Managerial Economics is economics applied in decision-making. It is that branch of economics
which serves as a link between abstract theory and managerial prac ce. It is based on
economic analysis for iden fying problems, organising informa on and evalua ng
alterna ves. Economics as a science is concerned with the problem of alloca on of scarce
resources among compe ng ends. These problems of alloca on are regularly confronted by
individuals, households, firms as well as economies.
DEFINITION
In the words of Spencer and Siegelman: “Managerial economics...is the integra on of
economic theory with business prac ce for the purpose of facilita ng decision-making and
forward planning by management.”
In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applica ons of
economics theory and methodology to business administra on prac ce”.
Managerial Economics bridges the gap between tradi onal economics theory and real
business prac ces in two ways. First it provides a number of tools and techniques to enable
the manager to become more competent to take decisions in real and prac cal situa ons.
Secondly it serves as an integra ng course to show the interac on between various areas in
which the firm operates.
C. I. Savage & T. R. Small therefore believes that managerial economics ―is concerned with
business efficiency.
FEATURES
a) Managerial economics is concerned with decision-making of economic nature. This
implies that managerial economics deals with iden fica on of economic choices and
alloca on of scarce resources.
b) Managerial economics is goal-oriented and prescrip ve. It deals with how decisions
should be made by managers to achieve the organisa onal goals.
c) Managerial economics is pragma c. It is concerned with those analy cal tools which
are useful in improving decision-making.
d) Managerial economics is both ―conceptual and metrical‖. An intelligent applica on
of quan ta ve techniques to business presupposes considered judgement and hard
and careful thinking about the nature of the par cular problem to be solved.
e) Managerial economics provides necessary conceptual tools to achieve this. Moreover,
it helps the decision-maker by providing measurement of economic en es and their
rela onships. This metrical dimension of managerial economics is complementary to
its conceptual framework.

NATURE OF MANAGERIAL ECONOMICS

Managerial economics is concerned with the business firm and the economic
problems that every business management need to solve.
MACRO-ECONOMIC CONDITIONS
We know that the decisions of the firm are made almost always within the broad
framework of economic environment within the firm operates, known as macro-
economic condi ons. With regard to these condi ons, we may stress three points:
a) The economy in which the business operates is predominantly a free enterprise
economy using prices and market.
b) The present-day economy is the one undergoing rapid technological and
economic changes.
c) The interven on of government in economic affairs has increased in recent
mes and there is no likelihood that this interven on will stop in future.
MICRO-ECONOMIC ANALYSIS
The micro-economic analysis deals with the problems of a individual firm, industry,
consumer, etc. In the case of managerial economics, micro-economics helps in
studying what is going on within the firm; how Op mal Solu on to Business Problems
Decision Problem Tradi onal Economics.
Managerial Economics Decision Sciences (Tools and Techniques of analysis) 6 best to
use the available scarce resources between various ac vi es of the firm; how to be
technically as well as economically efficient. Managerial economics also uses some of
the well-accepted models in price theory, such as the model for monopoly price,
kinked demand model, the model of price discrimina on and the behavioural and
managerial models.
POSITIVE VS NORMATIVE APPROACH
Whether one is using micro-economic analysis or macro-economic analysis, one can
take recourse to posi ve approach or norma ve approach or both. Posi ve approach
concerns with what is, was, or will be, while norma ve approach concerns with what
ought to be. The statement a government deficit will reduce unemployment and
cause an increase in prices is a hypothesis in posi ve economics, while the statement
in se ng policy, unemployment ought to ma er more than infla on‘ is a norma ve
hypothesis.
SCOPE OF MANAGERIAL ECONOMICS
Managerial economics has a close connec on with economic theory (micro-economics as well
as macroeconomic) opera ons research, sta s cs, mathema cs and the theory of decision-
making. Managerial economics also draws together and relates ideas from various func onal
areas of management like produc on, marke ng, finance and accoun ng, project
management, etc. A professional managerial economist has to integrate concepts and
methods from all these disciplines and func onal areas in order to understand and analyse
prac cal managerial problems. In so far as managerial economics is concerned, the following
aspects cons tute its subject-ma er:

 Objec ves Of A Business Firm

 Demand analysis and Demand forecas ng
 Produc on and Cost
 Compe on
 Pricing and Output
 Profit
 Investment and Capital Budge ng and
 Product Policy, Sales Promo on and Market Strategy.

Managerial Economics and its Relevance in decision making

Business firms are a mixture of personnel, financial and physical resources that aid in
managerial decision making. It is possible to divide communi es into two major categories −
output and consump on. Companies are economic bodies that are on the produc on side
while customers are on the distribu on side.

a) Managerial economics presents various aspects of tradi onal economics, relevant for
business decision-making in real life. It derives the ideas, principles and techniques of
analysis from economic theory, which have a impact on the decision-making process.
Those are adopted or changed to allow the manager to take be er decisions when
appropriate. Therefore, the goal of construc ng a suitable package from conven onal
economics was achieved by managerial economy.
 b) Managerial economics also incorporates important ideas from other disciplines such
as psychology, sociology, etc; if they are found relevant for decision-making. In
addi on, managerial economics takes advantage of other academic disciplines which
have a bearing on a manager's business decisions in view of the various explicit and
implicit constraints within which resource alloca on is to be op mised.
c) Managerial economics helps in formula ng variety of business decisions in a
complicated environment like what commodi es should be produced? What inputs
and produc on techniques should be used? How much output should be produced
and at what prices it should be sold? What are the best sizes and loca ons of new
plants? Etc.
d) Managerial economics transforms a boss into a more professional model maker.
Therefore, he can capture the important rela onship that characterizes a situa on
while leaving out the peripheral rela onships and clu ering details.
e) At the firm level, where for various func onal areas, exist, such as finance, marke ng,
HR, produc on, etc. Managerial economics serves as an integra ng agent by
coordina ng the different areas and brings together the decisions of each
department. This also makes corporate decision-making not in water ght
compartments but in an integrated context, the essence of which lies in the fact that
func onal divisions or experts frequently enjoy tremendous flexibility and accomplish
compe ng goals.

Managerial economics takes a cognizance of the interac on between the firm and society
and accomplishes the key role of business as an agent in the a ainment of social and
economic welfare. It has come to be recognized that business has other social
responsibili es besides its responsibili es to shareholders. Management economics
focuses emphasis on such social commitments as constraints that are subject to business
decisions. It acts as an instrument for the development of society's economic wellbeing
through socially mo vated business decisions.

ROLE OF A MANAGERIAL ECONOMIST IN BUSINESS

Making decisions and processing informa on are the two primary tasks of managers. While
we separate these two tasks for analy cal purposes, in reality they are prac cally inseparable.
That is, in order to make intelligent decisions, managers must be able to obtain process and
use informa on. The task of organising and processing informa on and then making an
intelligent decision based upon this informa on and the basic theory can take two general
forms:

- Task of making specific decisions by managers and

- General task of managers to use readily available informa on to make a decision or carry
out a course of ac on that furthers the goals of the organisa on.

i) Specific decisions:

There are several specific decisions that managers might have to take Eg., whether or not to
close down a branch of a firm that has recently been unprofitable ; whether or not a store
should stay open more hours a day; or whether to pay for outside compu ng or copying
services rather than install an in-house computer or copier. A er conduc ng a survey of Bri sh
industry, Alexander and Kemp came to the conclusion that the managerial economist
undertakes the following specific func ons:

i. Produc on scheduling

ii. Demand forecas ng

iii. Market research

iv. Economic analysis of the industry

v. Investment appraisal

vi. Security management analysis

vii. Advice on foreign exchange management

viii. Advice on trade

ix. Pricing and the related decisions and

x. Analysing and forecas ng environmental factors.

ii) General tasks:

Economic theory helps decision makers to know what informa on is necessary to make an
intelligent decision to find the correct solu on to a problem and to learn how to process and
use that informa on. We find that business is influenced by two sets of decision factors:

External factors and

Internal factors.

Business is influenced not only by decisions are taken within the firm but also by the general
business environment. While the internal factors are within its control, the external factors lie
outside its sphere of control. The firm can make only mely adjustments to these external
factors. The role of the managerial economist is to understand these external factors and to
suggest policies which the firm should follow to make the best use of these external and
internal factors.

(a) External factors:

The most important external factor is the general economic condi on of the economy, such
as the level and rate of growth of na onal income, regional income distribu on, influence of
interna onal factors on the domes c economy, the business cycle etc.,

The second important external factor for a firm is the prospects of demand for the product.
Is there a change occurring in the purchasing power of the public in general or in some
par cular regions?

Thirdly, the managerial economist also tries to find out if there is anything which is influencing
the input cost of the firm. For example, what about the cost of labour in different regions and
for different opera ons? What about the credit condi ons in the market? Is there going to be
some change in the government credit policies? How different inputs can be combined to
minimise the cost of produc on? And so on.
Fourthly, the market condi ons of raw material and finished product is also a subject of study
by the managerial economist. He has to understand the nature of the markets from which the
firm is buying its raw materials and of the market where it is selling its output. This
understanding helps the managerial economist to recommend a pricing policy for successful
management of the firm.

Next, managerial economist can also help in the expansion of the firm‘s share in the market.
He is to find out the opportuni es and the policies which help in the expansion of the firm‘s
share in the local and internal markets. This he can do y understanding the nature and trend
of demand.

(a) Internal factors

The role of managerial economist in internal management is as important as his contribu on

towards the management of external factors. He helps in deciding about the produc on, sales
and inventory schedules of the firm. He not only provides informa on regarding their present
level but also forecasts their future trend.

In short, the first role of a manager is to recognise a problem or to see a possible way to
further the goal of the organisa on, and then to obtain and process informa on in order to
make decision or reach a solu on. His second task is to use readily available informa on to
make a decision or carry out a course of ac on that furthers the goals of the organisa on.
Successful managers know how to pick out the useful informa on from the vast amount of
informa on they receive. In all these roles of a manager, the knowledge of managerial
economics is extremely helpful.

THE FUNDEMENTAL CONCEPTS

Economic theory provides a number of concepts and analy cal tools which can be of
considerable help to a manager in taking scien fic decisions and business planning. The basic
concepts which form the basis of managerial economics are the following:

 Incremental reasoning
 Opportunity cost
 Time perspec ve
 Time value of money- Discoun ng principle and

THE CONCEPT OF INCREMENTAL REASONING

The incremental reasoning involves es ma ng the impact of decision alterna ves. The two
basic concepts in the incremental analysis are: incremental cost and incremental revenue.
Incremental cost may be defined as the change in total cost as a result of change in the level
of output, investment, etc. Incremental revenue is a change in total revenue resul ng from
a change in the level of output, price etc.
To illustrate, let us take a case where a firm gets an order which can get it addi onal revenue
of Rs. 2,000.

The normal cost of produc on of this order is:

Labour Rs. 600

Materials Rs. 800

Overheads Rs. 720

Selling and administra on expenses Rs. 280

Full cost Rs. 2,400

Comparing the addi onal revenue with the above cost will suggest that the order is
unprofitable. But in case of order is accepted it would need the use of some of the exis ng
facili es and underu lised capacity of the firm. It would, add to cost much less than Rs.
2,400. May be, only a marginal addi on is required on overheads, some labour which was
par ally idle is be er u lised and there is no addi on to selling and administra on
expenses, i.e., the addi on to cost due to this new order is ,say, the following:

Labour Rs.400

Materials Rs. 800

Overheads Rs. 200

Total increment cost Rs. 1,400

In the above case, the firm would earn a net profit of Rs. 2,000 – Rs. 1,400= Rs.600, while at
first it appeared that the firm would make a loss of Rs.400 by accep ng the order.

A variant of incremental reasoning is the concept of marginal equivalency which takes into
account the change in dependent variable due to a unit change in independent variable.

CONCEPT OF OPPORTUNITY COST

Resources being scarce, we cannot have everything we want. We are, therefore, forced to
make a choice. If we want to choose to have more of one thing, it will be necessary to have
less of the other thing.

For ex:- id the firm wants to produce more of good X then( given resources) it will produce
less of good Y. Thus, producing a greater amount of X has opportunity cost of producing less
Y. Opportunity cost of a decision is the sacrifice of alterna ves required by that decision.
Sacrifice of alterna ves 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 pursing one
course of ac on rather than another. When a choice is made in favour of a par cular
alterna ve that appears to be most desirable of all the given alterna ves, it obviously implies
that the best alterna ves which has been sacrificed due to the best alterna ve is known as
opportunity cost of the best alterna ve.

(a) The opportunity cost of the funds employed one‘s own business is the amount of interest
which could have been earned had these funds been invested in the next best channel of
investment.

(b) When a product X rather than a product Y is produced by using a machine which can
produce both the opportunity cost of producing X is the amount of Y sacrificed as a result.

(c) The opportunity cost of using an idle machine is zero, as its use needs no sacrifice of
opportuni es.

(d) The opportunity cost of one‘s labour in one‘s own business is the income one could have
earned by accep ng a job outside.

Thus it is clear that opportunity cost requires that sacrifices must be clearly ascertained. If
there are no sacrifices there is no opportunity cost. These sacrifices may be monetary or
real. Monetary costs can be expressed as explicit, while real costs are implicit.

Rs. Explicit costs are recognised in accounts eg., the payments for labour, raw materials etc.

Implicit costs are sacrifices that are not recorded in accounts, eg, cost of capital supplied by
owners of business. Since opportunity cost includes both the explicit and implicit costs the
opportunity cost of alterna ve therefore is generally higher than its accoun ng cost.

TIME PERSPECTIVE

Economists o en make a dis nc on between short run and long run. They use these terms
with a precision that is o en missed in ordinary discussion. By short run they mean that period
within which some of inputs (called fixed inputs) cannot be altered, while in the long run all
the inputs can be changed (i.e., there are no fixed inputs). Thus, in the short run, change in
output can be achieved by changing the intensity of use of fixed inputs, while the same can be
achieved in the long run by adjus ng the scale of output, size of the firm, etc., Economists try
to study the effect of policy decisions on variables like prices, costs, revenue, etc., in the light
of these me dis nc ons.

THE DISCOUNTING PRINCIPLE

This concept is, in a way, an extension of the concept of me perspec ve. Since future is
unknown and incalculable, there is a lot of risk and uncertainty about future. Moreover, the
return in future is less a rac ve than the same return today. The future must, therefore, be
discounted both for the elements of delay and risk of future. The concept of discoun ng future
is based on the fundamental fact that a rupee now is worth more than a rupee earned a year
a er.

Suppose an investor wants to invest Rs.100, assuming that the bank rate of interest is 10%.
Now, had he not invested he would have earned at least this rate of interest and his money
would have grown from Rs.100 to Rs. 110 next year. In other words, Rs.110 next year has a
present worth, of Rs.100, i.e., to him Rs.110 next year are equal to Rs.100 today. Thus, in
case of present worth, we bring all of the future rupees up to today‘s rupees.
The Equi-Marginal Principle

The equi-marginal principle states that by keeping other things constant, if a consumer spends
his income on different commodi es, he or she will get maximum sa sfac on when marginal
u lity per unit of money is the same for each commodity.

This principle is also known as the law of subs tu on or the law of maximum sa sfac on. This
principle is used to find consumer equilibrium when a consumer consumes mul ple
commodi es.

Let’s take an example to simplify the concept, a firm is engaging in five different produc on
ac vi es i.e. A, B, C, D, and E with 100 number/ unit of labour. Now, if a firm wants to
increase output of ac vity B by employing more labour, it can only be possible by reducing
number of labour employed on other ac vi es. Moreover, the op mal alloca on can only
be a ained if marginal u lity from ac vity B is greater than the marginal produc vity from
another ac vi es. In this way, the total produc vity/u lity from all ac vi es will be
maximum. The concept of equi-marginal is also used for investment decisions and
distribu on of research expenditure. A consumer applies this concept to assure that the
money to be spend on different commodi es in such a way that the marginal benefit/u lity
yielding from one commodity will be equal to the marginal u li es from other commodi es.
Similarly, a producer applies this concept to insure that the total marginal product yielding
from all ac vi es will be maximum.

Theory of Consumer Behaviour

Managerial economies is just not about graphs and sta s cs, it deals with the human
behaviour and wants. The theory of consumer behaviour is the study of how consumers
allocate and spend their income among all the different goods and services based on their
individual preferences and budget constraints. This branch of microeconomics analyses the
consumer choices. The following two core approaches of consumer behaviour are used
widely- Cardinal U lity analysis and Ordinal U lity Analysis

Cardinal U lity Analysis

Introduc on

The famous neo-classical economists named Dupit, Walras, and Jevons introduced the
concept of cardinal u lity analysis disapproving the classical theories given by Adam Smith and
others. A er that Pigou and Marshall also elaborated the cardinal theory of consumer
behaviour.

Cardinal u lity analysis explains the demand of the consumer for a par cular commodity and
then stems the law of demand which indicates a counter associa on between price and
demanded quan ty of the product. Cardinal u lity analysis states that the u lity can be
measured in cardinal numbers which can be added or subtracted like 1, 2, 3, etc.

The term U l is coined by the famous economist Fisher as the measurement of u lity.

Defini ons According to Jevos, who first introduced the concept of u lity, “U lity is the basis
on which the demand of an individual for a commodity depends upon”.

In the words of Prof. Waugh, “U lity is the power of commodity to sa sfy human wants.”
Characteris c of U lity

i) U lity has no Ethical or Moral Importance but has the u lity, for example alcohol,
cigare e, knife, etc.
ii) U lity is psychological and differ from consumer to consumer.
iii) U lity is rela ve/ individual and differ in different situa ons in rela on to place and
me like woollen cloths and air condi oner.
iv) U lity is not necessary to be useful as a cigare e has u lity to the smoker but injurious
to health.
v) U lity is always subjec ve and cannot be measured objec vely as a consumer’s
feeling cannot be expressed in numerical terms.
vi) The intensity of a consumer’s want defined u lity as we want more of a commodity
if we have less and vice-versa.
vii) U lity is differ from pleasure and sa sfac on. For example, the medicine or an
injec on is necessary for the pa ent, but it will not offer any pleasure to the
consumer.

Assump ons of Cardinal U lity Analysis

The concept is based on certain assump ons:

i) Cardinal Measurement: This approach consider u lity as a measurable and

quan fiable en ty. An individual express that he derives 10 or 20 u ls from a
consump on of a cup of tea.
ii) Independent U li es: The u lity gained from consump on of one commodity is the
func on of that par cular commodity and u lity gained from a good does not depend
upon the consumed quan ty of other commodity.
iii) Consumer is ra onal: A consumer is assumed to be ra onal who want to maximize
his level of sa sfac on from his limited income.
iv) Marginal U lity of Money is constant: Daniel Bernoulli first introduced this no on but
later Marshall adopted this in his famous book “Principles of Economics’. According
to this assump on, the money’s marginal u lity remain constant throughout the
consumer spending.
v) DMU: Diminishing marginal u lity (DMU) concept is assumed in cardinal u lity
analysis. The marginal u lity of a commodity always diminish a er consuming more
and more unit of a commodity.
vi) Introspec ve Method: The behaviour of marginal u lity is arbitrated by introspec ve
method or we can say by self-observa on.

The concept of ordinal u lity

The concept of ordinal u lity states that the level of sa sfac on a consumer obtains
a er consuming various commodi es cannot be measured in numbers but can be
arranged in the order of preference.
 Difference between Cardinal u lity and Ordinal u lity

Cardinal Utility Ordinal Utility

Definition

It explains that the satisfaction level It explains that the satisfaction level after consuming
after consuming any goods or services any goods or services cannot be scaled in numbers.
can be scaled in terms of countable However, these things can be arranged in the order of
numbers. preference.

Example

Pizza gives Sam 60 utils of satisfaction, Sam gets more satisfaction from a pizza as
whereas burger gives him only 40 utils. compared to that of a burger.

Measurement

Utility is measured based on utils. Utility is ranked based on satisfaction.

Realistic

It is less practical. It is more practical and sensible.

Used By

This theory was applied by Prof. Marshall This theory was applied by Prof. J R Hicks