BUSINESS ECONOMICS

INTRODUCTION TO BUSINESS ECONOMICS

In life, everyone wants an infinite number of things but we only have

finite resources to acquire what we want. Maintaining an efficient
balance between these unlimited wants and limited resources is what
Business Economics deals with. Therefore, understanding
the Meaning of Business Economics is extremely crucial. But when
we are talking about business economics we consider the needs of a
bigger entity, for example, a nation, a firm, etc.

Meaning of Business Economics

To understand the meaning of business economics we can think of
Business Economics as the integration of two major
concepts: Economic Theory + Business Practices. It helps in making
the best decision based on the analytical tools of Economic Theory
and best-suited Business Policies defined within Business Practices.

Economic Theory

It consists of various techniques such as demand-supply, cost, and

consumption to analyse all aspects of a business situation. Also, it
provides us with the past and present information regarding the
growth in production and demands.
It is because of Economic Theory that we know that both Quantity
and Quality of Resources whether Human or Non-human has
improved with time. But what it fails to clarify is the reason behind a
non-smooth growth pattern. This is where Business Economics
comes into play.

Business Economics

Business Economics gives information about the elements that affect

(increase or decrease) the production efficiency of resources. It helps
to examine economic issues for selecting the best course of action
from all the ones available.

This course of action directly influences the performance of a

business. So, it is important to make a sound decision. This brings us
to our next vital point of focus, Decision Making.

Decision Making

In Business, allocation of resources is a very crucial task. And, there

are always several alternatives (recipients of the resources) present.
Now Evaluating all the alternatives based on the information
collected and choosing the most efficient one is nothing but Decision
Making.

An economic issue becomes more complex because it is based on

political and social issues as well. Making a decision is again
challenging because we make a decision on the basis of non-exact
knowledge with an uncertain future.

In such cases, the best that we can do from our side is making the
management to acquire the data known as accurately as possible. For
this, management needs to be provided with precise tool exact
analytical methodologies.

As redressing the Management is also a part of decision making,

Business economics is also called Managerial Economics.

More to know about Business Economics:

It is a part of Applied Economics. Apart from Economic theory and

Business Practices, Business Economics encompasses the following
fields of study too:

 Operations research
 Theory of decision making
 Mathematics
 Statistics
The quantitative techniques that are used:

 Capital Budgeting: analysing the worth of a firm’s long-term

investments.
 Cost Analysis: to examine the pros and cons of an aspect of a
business and determining the best one.
 Regression Analysis: to find a relationship between two important
variables statistically.
 Break-Even Analysis: determining the optimum sales targets to be
reached within a given duration of time to even out the cost of
doing business.
 Linear Programming: techniques to optimise a business value such
as output or cost.
Nature of Business Economics
For a layman, the economic world is a complex place. Usually,
economic theories are simple and hypothetical in nature. Hence, most
managers find a difference between the propositions of these theories
and the real economic world. This is where Business
Economics steps in. It enables the application of economic logic and
analytical tools and attempts to bridge the gap between theory and
practice. In this article, we will describe the nature of business
economics to help understand the economic theories better.

Before we start to study the nature of business economics, it is

important to understand that economics is broadly divided into two
major parts:

 Micro Economics
 Macro Economics

Micro Economics
This is the study of the way individual units make decisions
regarding the efficient allocation of their scarce resources. Also, these
individual units are consumers or firms.

In microeconomics, the focus is on a small number of units rather

than all units combined. Further, it does not give us a picture of the
happenings in the wider economic environment. The study includes:

 Product pricing;
 Consumer behavior;
 Factor pricing;
 The economic conditions of a section of people;
 The behavior of firms; and
 Location of the industry.

Macro Economics
This is the study of the behavior of large economic aggregates like
overall output levels, total consumption, etc. The study also includes
the shift of these aggregates over time. Therefore, macroeconomics
analyzes the overall economic conditions which are an overall effect
of millions of decisions made by different firms and consumers.

 National Income and National Output;

 The general price level and interest rates;
 A balance of trade and balance of payments;
 The external value of currency;
 The overall level of savings and investment; and
 Level of employment and rate of economic growth.

Nature of Business Economics

Business Economics is a Science
What is Science? It is simply a systematic body of knowledge which
can establish a relationship between cause and effect. Further,
Mathematics, Statistics, and Econometrics are decision sciences.

Business Economics integrates these decision sciences with

Economic Theory to arrive at strategies to help businesses achieve
their goals. Hence, it follows scientific methods and also tests the
validity of the results. This is one aspect of the nature of business
economics.

It is Based on Micro Economics

We understand the basic difference between micro and

macroeconomics. A business manager is certainly more concerned
about achieving the objectives of his own organization. After all, this
helps him in ensuring profits and long-term survival of the firm.

Business Economics is more concerned with the decision-making

situations of individual establishments. Therefore, it depends on the
techniques of Microeconomics.

It Incorporates Elements of Macro Analysis

Even though all businesses focus on their profitability and survival, a

firm cannot operate in a vacuum. The external environment of the
economy like income and employment levels in the
economy, tax policies, etc., affects the firm. All these external factors
are components of Macroeconomy.

Therefore, a business manager has to take all such factors

into consideration which may influence his business environment.

It is an Art

Business Economics is an art as it requires the practical application of

rules and principle to achieve set objectives.
Use of Theory of Markets and Private Enterprises

Business Economics primarily uses the theory of markets and private

enterprises. It uses the theory of the firm and resource allocation in a
private enterprise economy.

Pragmatic in Approach

Microeconomics is purely theoretical and analyzes economic

occurrences under unrealistic assumptions. On the other hand,
Business Economics is pragmatic in its approach. It tries to solve the
problems which the firms face in the real world.

Interdisciplinary

Business Economics incorporates tools from many other disciplines

like mathematics, statistics, accounting, marketing, etc. Therefore, is
in interdisciplinary in nature.

Normative

Broadly speaking, Economic Theory has evolved along two lines –

Positive and Normative.

A positive or pure science analyzes the cause and effect relationship

between variables in a scientific manner. However, it does not
involve any value judgment. In simpler words, it describes
the economic behavior of individuals or society without focusing on
the desirability of such behavior.

On the other hand, normative science involves value judgments. It

suggests a course of action under the given circumstances.

Usually, Business Economics is normative in nature. It offers

suggestions for the application of economic principles while forming
policies, making decisions, and planning for the future. However,
firms must understand their environment thoroughly to establish
decision rules. This requires the study of positive economic theory.

Therefore, we can say that Business Economics combines the

essentials of both the theories while keeping more emphasis on the
normative economic theory.

Scope of Business Economics

Business Economics covers most of the problems that a manager or
establishment faces. Hence, the scope of business economics is wide.
Since a firm can face internal/operational as well as external and/or
environmental issues, there are different economic theories
applicable to them. Microeconomics helps with internal or
operational issues whereas macroeconomics is applied to external or
environmental issues. In this article, we will look at the scope of
business economics under both these heads.

Some Point of Scope of Business Economics

I. Microeconomics Applied to Operational Issues

As the name suggests, internal or operational issues are issues that

arise within a firm and are within the control of the management. It is
within the scope of business economics to analyze this.

Further, a few examples of such issues are choice of business, size of

business, product designs, pricing, promotion for sales, technology
choice, etc. Most firms can deal with these using the following
microeconomics theories:

1. Analyzing Demand and Forecasting

Analyzing demand is all about understanding buyer behavior. It

studies the preferences of consumers along with the effects of
changes in the determinants of demand. Also, these determinants
include the price of the good, consumer’s income, tastes/ preferences,
etc.

Forecasting demand is a technique used to predict the future demand

for a good and/or service. Further, this prediction is based on the past
behavior of factors which affect the demand. This is important for
firms as accurate predictions help them produce the required
quantities of goods at the right time.

Further, it gives them enough time to arrange various factors

of production in advance like raw materials, labor, equipment, etc.
Business Economics offers scientific tools which assist in forecasting
demand.

2. Production and Cost Analysis

A business economist has the following responsibilities with regards

to the production:

 Decide on the optimum size of output based on the objectives of

the firm.
 Also, ensure that the firm does not incur any undue costs.
By production analysis, the firm can choose the appropriate
technology offering a technically efficient way of producing the
output. Cost analysis, on the other hand, enables the firm to identify
the behavior of costs when factors like output, time period, and the
size of plant change. Further, by using both these analyses, a firm can
maximize profits by producing optimum output at the least possible
cost.

3. Inventory Management

Firms can use certain rules to reduce costs associated with

maintaining inventory in the form of raw materials, work in progress,
and finished goods. Further, it is important to understand that the
inventory policies affect the profitability of a firm. Hence,
economists use methods like the ABC analysis and mathematical
models to help the firm in maintaining an optimum stock of
inventories.

4. Market Structure and Pricing Policies

Any firm needs to know about the nature and extent of competition in
the market. A thorough analysis of the market structure provides this
information. Further, with the help of this, firms command a certain
ability to determine prices in the market. Also, this information helps
firms create strategies for market management under the given
competitive conditions.

Price theory, on the other hand, helps the firm in understanding how
prices are determined under different kinds of market conditions.
Also, it assists the firm in creating pricing policies.

5. Resource Allocation

Business Economics uses advanced tools like linear programming to

create the best course of action for an optimal utilization of available
resources.

6. Theory of Capital and Investment Decisions

Among other decisions, a firm must carefully evaluate its investment

decisions an allocate its capital sensibly. Various theories pertaining
to capital and investments offer scientific criteria for choosing
investment projects. Further, these theories also help the firm in
assessing the efficiency of capital. Business Economics assists the
decision-making process when the firm needs to decide between
competing uses of funds.

7. Profit Analysis

Profits depend on many factors like changing prices, market

conditions, etc. The profit theories help firms in measuring and
managing profits under such uncertain conditions. Further, they also
help in planning future profits.

8. Risk and Uncertainty Analysis

Most businesses operate under a certain amount of risk and

uncertainty. Also, analyzing these risks and uncertainties can help
firms in making efficient decisions and formulating plans.

II. Macroeconomics applied to Environmental Issues

External or environmental factors have a measurable impact on the

performance of a business. The major macroeconomic factors are:

 Type of economic system

 Stage of the business cycle
 General trends in national income, employment, prices, saving, and
investment.
 Government’s economic policies
 Performance of the financial sector and capital market
 Socio-economic organizations
 Social and political environment.
The management of a firm has no control over these factors.
Therefore, it is important that the firm fine-tunes its policies to
minimize the adverse effects of these factors.

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Relationship of Economics with Other
Subjects
Economics is classified as a social science. This view makes eco-
nomics an academic relative of political science, sociology,
psychology and anthropology. All of these disciplines study the
behaviour of human beings individually and in groups.

They study different subsets of the actions and’ interactions o

human beings. For this reason they also are sometimes termed
behavioural sciences. We may now make a brief review of the
relation between economics and other related disciplines such as
psychology and sociology.

Economics and Psychology:

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Economics is particularly concerned with consumption,

production and resource use by individuals and groups.
Economics is also concerned with the procures by which
households and firms make decisions about the use of scarce
resources.

Inevitably, this definition of the ‘territory’ of economics leads to

some overlapping with the other disciplines. Psychologists and
economists share an interest in what motivates people to take
certain action.

However the primary interest of economists lies in those actions

that are reflected in market activity or in economic decisions
made through government.

Economics and Sociology:

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While sociologists are interested in all facts of organised human

activity, economists are interested mainly in organised activities
that related o the production and consumption of goods and
services. As a general rule economists assume that individuals
pursue their self-interest and respond to various signals or
incentives in the light of that self-interest.

Although this may seem obvious, it is somewhat different

viewpoint on human behaviour from that of psychologists and
sociologists. This perspective often leads economists to draw
different conclusions.

Economics and Political Science:

Economics interacts with almost all other academic disciplines. It

is intimately intertwined with current events, and it has a
significant effect on political events, both domestic and
international. Economics has various things common with
political science. For example, in both subjects we teach public
finance, financial relations between the centre of the study as also
the economics of planning.

Economics and Decision Sciences:

Economics is also part of a group of disciplines called decision

sciences which includes some branches of statistics, applied
mathematics, operational research, and some areas of
management and engineering. All of these disciplines deal with
how individuals and groups make decisions.

Economists are specifically interested in those decisions relating

to production consumption and resource use. As a decision
science, economics is closely related to business and management
courses.

Economics and Statistics:

 One major function of an economist is to conduct research. The
job of the company economist is to investigate economic aspects
of various decisions Government agencies and private business
firms generate a vast array of economic statistics on such matters
as income, employment, prices and expenditure patterns. A two-
way street exists between statistical data and economic theory.

Statistics can be used to test the consistency of economic theory

and measure the responsiveness of economic variables to changes
in policy. At the same time, economic theory helps to explain
which economic variables are likely to be related and why they
are linked. Statistics do not tell their own story.

Fundamental Economics Tools

Basic Economic Tools in Managerial Economics for Decision Making
 Opportunity cost.
 Incremental principle.
 Principle of the time perspective.
 Discounting principle.
 Equi-marginal principle.

1. Opportunity Cost Principle

By the opportunity cost of a decision is meant the sacrifice of alternatives required by
that decision. For e.g.

1. The opportunity cost of the funds employed in one’s own business is the interest that
could be earned on those funds if they have been employed in other ventures.
2. The opportunity cost of using a machine to produce one product is the earnings
forgone which would have been possible from other products.
3. The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate
of interest, which would have been earned had the money been kept as fixed deposit
in bank.

Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision
involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs
are the only relevant costs.

2. Incremental Principle
 It is related to the marginal cost and marginal revenues, for economic
theory. Incremental concept involves estimating the impact of decision alternatives on
costs and revenue, emphasizing the changes in total cost and total revenue resulting
from changes in prices, products, procedures, investments or whatever may be at stake
in the decisions.

The two basic components of incremental reasoning are

1. Incremental cost
2. Incremental Revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if —

 it increases revenue more than costs

 it decreases some costs to a greater extent than it increases others
 it increases some revenues more than it decreases others and
 it reduces cost more than revenues”

3. Principle of Time Perspective

Managerial economists are also concerned with the short run and the long run effects
of decisions on revenues as well as costs. The very important problem in decision
making is to maintain the right balance between the long run and short run
considerations.

For example; Suppose there is a firm with a temporary idle capacity. An order for 5000
units comes to management’s attention. The customer is willing to pay Rs 4/- unit or
Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the
fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/-
per Analysis:

From the above example the following long run repercussion of the order is to be
taken into account:

1. If the management commits itself with too much of business at lower price or with a
small contribution it will not have sufficient capacity to take up business with higher
contribution.
2. If the other customers come to know about this low price, they may demand a similar
low price. Such customers may complain of being treated unfairly and feel
discriminated against.
 In the above example it is therefore important to give due consideration to the time
perspectives. “a decision should take into account both the short run and long run
effects on revenues and costs and maintain the right balance between long run and
short run perspective”.

4. Discounting Principle
One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than
a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/-
today or Rs.100/- next year. Naturally he will chose Rs.100/- today. This is true for two
reasons-

1. The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present
opportunity is not availed of
2. Even if he is sure to receive the gift in future, today’s Rs.100/- can be invested so as to
earn interest say as 8% so that one year after Rs.100/- will become 108

5. Equi – Marginal Principle

This principle deals with the allocation of an available resource among the alternative
activities. According to this principle, an input should be so allocated that the value
added by the last unit is the same in all cases. This generalization is called the equi-
marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four
activities which need labors services, viz, A,B,C and D. it can enhance any one of these
activities by adding more labor but only at the cost of other activities.