Subject: Managerial Economics

Paper: 01, Managerial Economics

Module: 02, Overview of Important terms and concepts in Managerial Economics

Principal Investigator Prof. S P Bansal

Vice Chancellor
Maharaja Agrasen University, Baddi

Co-Principal Investigator Prof Yoginder Verma

Pro–Vice Chancellor
Central University of Himachal Pradesh. Kangra. H.P.

Prof. S.K. Garg

Paper Coordinator Former Dean and Director,
HPU, Shimla

Content Writer Dr. Savita

School of Management,
Maharaja Agrasen University, Baddi
 QUADRANT-I

1. Module 1: Managerial Economics:Conceptual Framework,Nature and scope

2. Learning Outcome
3. Introduction to Economic Concepts and Principle
4. Various Principles
5. Summary

2. Learning Outcome:
After having studied this module, one may be able:

1. To know the various concepts of Managerial economics.

2. To understand how these concepts are fundamental to business analysis and
decision-making.
3. To understand how these concepts are helpful to improve Managerial decision-
making.

3. Introduction

In due course of business, managers often encountered the various situations where they
require taking rational decision to ensure the smooth functioning of the organization. At the
same moment taking right decision at the right time is difficult task. Failure to do so may lead
to a sudden fall of business enterprise. Therefore, to arrive at the right decision one can make
use of Economic theories, concepts, and analytical tools.

4. Basic Tools in Managerial Economics or principles of Managerial Economics or

Fundamental Concepts of Managerial Economics:
Managerial Economics employs some well known tools of analysis. These tools are given
below in detail:

1. Principle of Opportunity cost

2. Principle of Incremental cost and revenue

3. Principle of Time perspective

4. Principle of Equi-marginal satisfaction and Productivity

5. Principle of Discounting

6. Principle of Risk and uncertainty

7. Principle of Optimisation

1.
• Principle of Opportunity cost

2.
• Principle of Incremental cost and revenue

3.
• Principle of Time perspective

4.
• Principle of Equi-marginal satisfaction

5.
• Principle of Discounting

6.
• Principle of Risk and uncertainty

7.
• Principle of Optimisation
 1. Opportunity Cost:

While taking decision in relation to any business activity we have to take into consideration
various alternatives. In Managerial economics, the opportunity cost is useful in decision
involving a choice between different alternative courses of action. The opportunity cost of
any decision is the sacrifice of the next best alternative course of action available to any firm.
If we don’t have to make any sacrifice then the opportunity cost is zero. Opportunity cost,
therefore represent the benefits or revenue foregone by pursuing one course of action rather
than another.

The concept of opportunity cost implies following things:

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

termed as the cost of sacrificed alternatives.
2. Sacrifices may be monetary or real.
3. The opportunity cost may also be interpreted as the cost of alternative which we have
to forego.
Further W.W.Haynes has clarified the meaning of the concept of opportunity cost
with the help of following examples:
  The opportunity cost of the funds tied up in one’s own business is the interest
(or profits corrected for differences in risk) that could be earned on those
funds in other ventures.
 The opportunity cost of the effort one puts into his own business is the salary
he could earn in other occupations (with a correction for the relative ‘phychic
income’ in the two occupations).
 The opportunity cost of using a machine that is useless for any other purpose
is nil. Since its use requires no sacrifice of other opportunities.
From the above examples it is clear that opportunity cost requires the
measurement of sacrifice. If there is no sacrifice involved by a decision, there
will be no opportunity cost. Though the opportunity cost is not recorded in the
books of accounts. It is an important consideration in business decisions.
The importance of opportunity cost is as follows:

a) It helps in determining the relative prices of goods.

b) It helps in determining normal remuneration to factors of production.
c) It helps in proper allocation of resources.

Thus we can say opportunity cost is the cost of next best alternative use. Following are the
various examples that illustrate the concept of Opportunity cost:

 The opportunity cost of the capital employed in the business is the interest that could
be earned on that capital which may be deposited in the bank.
 The opportunity cost of the time any person devotes to his own business is the salary
he could earn by being employed elsewhere.
 The opportunity cost of using a machinery to produce any product is the earnings
foregone which may be possible from the production of other products.
 An Ice cream making firm producing vanilla flavour ice cream can also make
pineapple flavour Ice Cream; in this case the opportunity cost of making vanilla is
the amount of the pineapple ice cream given up.
 The opportunity cost of holding Rs.10000/- as cash in hand for one year is the 8%
rate of interest, which would have been earned had the money been kept as fixed
deposit in a bank.
 Therefore, we can say that opportunity cost of anything is the next best alternative
that could be manufactured by the same factors and by the same amount of
expenditure. Thus opportunity costs must be considered by the managers before
taking any decision for business.
1. Incremental cost and revenue principle:

Incremental concept is another important concept. Incremental concept is in close relation to

the marginal costs and marginal revenues. Incremental concept implies measuring the
changes in total cost and total revenue due to change in the decision of the firm in relation to
changes in techniques of production, prices of products, investments, source of raw material
etc.

The two basic components of incremental reasoning are:

a) Incremental cost
b) Incremental revenue.
(a) Incremental Cost may be defined as the change in total cost as a result of a
particular decision. In simple words Incremental cost is the differential cost that must
be incurred if a decision is taken and that need not be incurred if the same is not
executed. It is a change in total cost due to a change in the level of the activity.
Incremental cost may be either fixed cost or variable cost. This is because a business
decision may require purchase of extra labour and raw materials to be used for
implementing the decision.
 http://images.wisegeek.com/water-bottles-on-conveyor-belt.jpg
In any case, a business decision may need additional capital equipment on which extra
cost has to be incurred. Let us further clear the concept of incremental cost. If some
factors in a firm are lying idle and have no alternative use, and if a particular decision
involves the use of these idle factors, then for calculation of incremental cost, the
costs incurred on these factors in the past must not be included for a particular
decision being presently considered since opportunity cost of these idle resources at
present is zero, they are not relevant from the economic point of view to be included
in the incremental cost. There are three types of incremental cost:
 Opportunity Cost: Opportunity cost or alternate cost is the cost that has been
forgone. It is a well known fact that a person can not satisfy all his wants. When he
satisfies one want he is to sacrifice the other wants, the sacrifice is the opportunity or
alternative cost. The concept of opportunity cost is very important in economic
analysis, particularly, in case of those factors which are scarce in the economy. A
significant fact is that relative prices of goods tend to show their opportunity cost. It is
opportunity cost of a factor which provides the chance of substituted one factor for the
other factor.
 Current Period Explicit Cost: Explicit costs include the payment which is made by
the producer to the factors other than his own factors. Explicit costs are mostly in the
nature of contractual payments made by the employer to the owners of those factors
whose services are hired by him for production. Current period explicit costs include
costs incurred on direct labour engaged, on purchase of new materials, certain type of
variable overhead costs such as an electricity consumption required to implement the
decision can be easily calculated.
  Future Costs: Not only the current costs associated with a given decision to be
considered but also the likely future costs any kind resulting from a given decision. It
may however be noted that to the extent these costs can be foreknown their expected
present value is estimated and included in the incremental cost of the decision.
(b) Incremental Revenue: Incremental revenue is the change in total revenue resulting
from the implementation of a particular decision. Increase in total revenue caused by
deciding about a relatively large change in output, say by 15%, introduction of a new
product line or a new technology or launching advertisement campaign expenditure is
called incremental revenue.

The incremental principle implies that a decision is profitable only if:

 It increases revenue more than costs

 It reduces costs more than revenues.
 It decreases some costs to a greater extent than it increases other costs
 It increases some revenues more than it decreases other revenue

For example: In Fire Fighting industry in order to cut the metal sheets for making fire
brigades gas cutting machines were used if a firm decides to go for CNC sheet cutting, the
additional revenue it earns will be termed ‘incremental revenue’ and the extra cost of setting
up CNC sheet cutter facilities will be termed incremental cost. Therefore, as stated earlier if
the incremental revenue is more than incremental cost resulting from a particular decision it
is acceptable and regarded as profitable.

Further it can be illustrated as:

Suppose a new order is estimated to bring additional revenue of Rs. 7,000. The costs are
estimated as under:

Material cost Rs.2, 000/-

Labour Cost Rs.3, 500/-

Overhead Cost Rs. 2, 500/-

Selling Cost Rs.1, 000/-

-----------------

Total cost Rs.9, 000/-

-----------------

As per the incremental principle the decision seems to be unprofitable.

Although the concept is widely followed by the Progressive concerns but it has a short run
approach and can only be used by the firms having idle production capacity.

Contribution analysis

Associated with the concept of incremental cost and incremental revenue is the concept of
contribution. It can be stated as the difference between the incremental revenue and the
incremental cost associated with that particular decision. This principle tells us that every
factor of production makes its own contribution to productivity for the firm and that this
contribution changes as the volume of output is changed. It is useful technique for taking a
decision on:

 Either accept the project or not,

 Either introduce a new project or not,
 Either accept a fresh order or not,
 Either add to an additional plant or not,
 Either make or to buy a product etc.

In order to use the contribution analysis for a business decision, one must know the
incremental cost and incremental revenue.
 https://images.contentful.com/91sm3pewxzag/3xLWwN4lK8Cyciy6ec2O6M/0fb29262a
6d484744aa8200f2c87a7ee/featured_contribution-analysis-report.png?w=950

3. Time perspective:

The concept of time element was introduced by Marshall. Time perspective principle
highlights that manager should give appropriate importance to short term and long term
effects of his decisions before arriving any decisions. In simple words, the decision of a
business firm should be taken only after considering the short-run and long-run effects of
decisions on costs and revenues. In managerial economics, the decisions and analysis are
classified into short and long period. While taking decision manager establishes balance
between short run and long run.
In short period firm can alter its level of production by changing only variable factor.
However, in long run firm can alter its level of production by changing variable as well as
fixed factors of production because of sufficient time availability.

In short run the average cost of the firm may be either more or less than its average revenue.
In the long period, the average cost is equal to average revenue. Many a times manager take
decision by taking into consideration short term factors but may have long term effects,
which make it more or less profitable than what it appears to manager at first instance. The
business decision-maker must assess and determine the time perspective well in advance and
make decisions accordingly. Determination of time perspective is of great significance
especially where projections are involved.

4. The Equi-marginal Principle:

Another important principle of economics is Equi-Marginal principle. It is also called

principle of equi-marginal satisfaction and productivity. Originally the concept is used in
relation to consumption. The Equi marginal principle states that a consumer will be in
equilibrium when the marginal utilities of various commodities consumed by him are equal.
This principle is also known as principle of maximum satisfaction. The law of equi-marginal
principle has been applied to the allocation of scarce resources among
their alternative uses with a view to maximizing profit in case a firm carries out
more than one business activity. According to this principle, an input should be allocated in
such a manner that the value added by the last unit of the input is the same in all uses. Hence,
this principle provides a basis for maximum exploitation of all the productive resources of a
firm so that the profitability of the firm may be maximised.

The Equi-marginal principle can be applied only where

(i) Firms have limited funds available for investment

(ii) Resources have alternative uses
(iii) The investment in various alternative uses is subject to diminishing marginal
productivity or returns.

Let us consider a case in which the firm is involved in four activities i.e. activity W, activity
X, activity Y, activity Z. All these activities require the services of labour. The firm can
increase any one of the activities by employing more labour, but only at the cost of other
activities. In this case, the firm allocates labour for each of the activity in such a manner that
the value of the marginal product is equal in all activities.

VMPw = VMPx = VMPy = VMPz

Where ‘L’ indicates labour and W,X,Y,Z represent the activities, that is, 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 X, and so on.

If the firm funds that the value of the marginal product is greater in one activity than another,
the firm must realize the fact that an optimum has not been achieved.

The equi-marginal principle can be applied in different areas of management:

a) It is used in budgeting. The objective is to allocate resources where they are most
productive. It can be used for eliminating waste in useless activities. The
management can accept investments with high rates of return so as to ensure optimum
allocation of capital resources.
b) The equi-marginal principle can also be applied in multiple product pricing. A
multi product firm will reach equilibrium when the marginal revenue obtained from a
product is equal to that of another product or products.
c) The Equi-marginal principle may also be applied in allocating research
expenditures.
5. Discounting Principle:
It is a fundamental principle of economics that the worth of a rupee receivable
tomorrow is lesser than that of a rupee available today. As it is mentioned in the time
perspective principles, if the decision affect the cost and revenue in the long run,
therefore all costs and revenue must be discounted to the present values before valid
comparison of alternatives is possible because people generally consider a rupee
tomorrow to be worth less than a rupee today. This is also implied by the common
saying that a bird in hand is worth than two in the bush. Anybody will prefer Rs. 1000
today to Rs. 1000 next year. There are two main reasons for this:
(1) The future is uncertain

(2) There is risk factor involved in the future.

Discounting can be defined as a process used to transform future rupees into an equivalent
number of present rupees. This is so because a rupee tomorrow to be worth less than a rupee
today. Money actually has time value. For example, Rs. 5000 invested at 10% will be
equivalent to Rs.5500 next year. Hence, the timing of receipt of an amount should be duly
taken into consideration in the solution of a particular problem relating to investment.

6. Principle of Risk and Uncertainty:

As we know future is uncertain. Whatever the investment are made today will yield
return in future. Change occurring in the economy on account of change in
government policy, change in business cycle and also on account of change in the
structure of economy.

Uncertainty and risk are correlated. Since managers cannot foresee the changes in the
future, decisions are taken may proved to be risky because of uncertainty in regard to
production, market prices, strategies of rival firms.
Also changes in the external economy are dynamic and beyond the control of the
firm, the outcome is risk and therefore returns cannot be estimated with certainty. One
of the well accepted principle is that profitability and risk are closely related. It is very
 likely that the project which seems to be profitable ay also increase the perceived risk
of an undertaking. This will certainly effect the decision of firm regarding acceptance
of project. The manager will not accept any investment proposal which seems to be
more risky and less profitable. Therefore it is very necessary to take into consideration
risk factor in the light of uncertain factors
7. Principle of Optimization:

This is yet another important concept used in managerial economics. Optimisation principle
aims at selecting an alternative whose cost is least or ensures highest returns under the given
constraints, by maximizing desired factors and minimizing undesirable factors. Maximisation
implies aiming to achieve the highest or maximum outcome without regard to cost or
expense. Managerial economics often aims at optimizing a given objective. The objective
may be maximization of profit or minimization of time or minimization of cost. The
important techniques for optimization include marginal analysis, calculus, linear
programming etc. In computer simulation of business problems optimization is achieved
generally by employing linear programming technique of operations research.

5. Summary

Managerial Economics has offered a number of concepts and principles which helps in
improving decision making process of any business concern and therefore suggesting the
answers to the practical problems faced by managers in their day routine. This module
presents some major concepts and their use in business decision making. It explains
opportunity cost and decision rule. The scarcity and the alternative uses of the resources give
rise to the concept of opportunity cost. This concept can be applied to all other kind of
resources involved in business decisions, particularly where there at least two alternative
options involving cost and benefits. Marginality concept assumes special significance where
maximisation or minimisation problem is involved. The use of incremental concept in
business decisions is called incremental reasoning. The incremental reasoning is used in
accepting or rejecting a business proposition or option. The law of equi-marginal principal
was over time applied by business managers to allocate of resources between their alternative
uses with a view to maximising profit in case a firm carries out more than one business
activity.