Economic theory offers a variety of concepts which can be of considerable

assistance to the managers in decision-making practices. These tools are

helpful for managers in solving business-related problems. These are thus taken
as guides in making decisions. The following arc the basic economic tools for
decision-making:

1. Opportunity cost principle

2. Incremental concept/principle
3. Principle of time perspective
4. Discounting principle
5. Equi-marginal principle.
Opportunity cost principle is related and applied to scarce resource. When
there are alternative uses of scarce resource, one should know which best
alternative is and which is not. We should know what gain by best alternative is
and what loss by left alternative is.
Devenport. an American Economist explains the concept of opportunity cost
with reference to an example. Suppose a girl had two kinds of fruits- one pear
and one peach, and if a bad boy is after her to seize the fruits, then the best way
for the girl is to drop one fruit and run with the other, so that, she can at least
save one fruit, at the cost of the other. When the girl so drops by the way - side
one fruit and runs with the other, then the opportunity cost of the fruit she saves
is the foregone alternative of the fruit she lost. This is the opportunity cost
theory.
The concept of opportunity cost plays an important role in managerial
decisions. This concept helps in selecting the best possible alternative from
among various alternatives available to solve a particular problem. This
concept helps in the best allocation of available resources.
The opportunity cost of any action is simply the next best alternative to that
action - or put more simply, "What you would have done if you didn't make the
choice that you did".

The income or benefit foregone as the result of carrying out a particular

decision, when resources are limited or when mutually exclusive projects are
involved.
Definitions
— In the words of Left witch, "Opportunity cost of a particular product is the
value of the foregone alternative products that resources used in its production,
could have produced."
Opportunity cost is not what you choose when you make a choice —it is what
you did not choose in making a choice. Opportunity cost is the value of the
forgone alternative — what you gave up when you got something.
Example 1:
If a person is having cash in hand Rs. 100000/-, he may think of two
alternatives to increase cash.
Option 1: Investing in bank. We will get returns amount 10000/-
Option2: Investing in business. We get returns amount 17000/-
Generally we chose the option 2 because we will get more returns than the
option 1. Here the option 1 is the opportunity cost, that what we have not
chosen.
Example 2:
I have a number of alternatives of how to spend my Friday night: I can go to
the movies; I can stay home and watch the baseball game on TV, or go out for
coffee with friends. If I choose to go to the movies, my opportunity cost of that
action is what I would have chosen if I had not gone to the movies - either
watching the baseball game or going out for coffee with friends. Note that an
opportunity cost only considers the next best alternative to an action, not the
entire set of alternatives.
The opportunity cost of a decision is based on what must be given up (the next
best alternative) as a result of the decision. Any decision that involves a choice
between two or more options has an opportunity cost.
The main objective of incremental principle is maximization of profits or in
other words to raise the profits in the business
General rule:
By increasing in the production, the total cost of the product raises and
simultaneously profit also rises.
Practicality in the business:
How much extra we should produce to get the best profits and how much extra
cost would be incurred for the extra production.
Incremental concept involves estimating the impact of decision alternatives on
costs and revenues, emphasizing the changes in total cost and total revenue
resulting from changes in prices, products, procedures, investments or whatever
else may be at stake in the decisions. The two basic components of incremental
reasoning are:
1. Incremental cost
2. Incremental revenue.
Incremental cost may be defined as the change in total cost resulting from a
particular decision. Incremental revenue is the change in total revenue resulting
from a particular decision.

The incremental principle may be stated as follows: A decision is a profitable

one if—
1. it increases revenue more than cost
2. it decreases some costs to a greater extent than it increases others
3. it increases some revenues more than it decreases others and
4. it reduces cost more than revenues.
Suppose a firm gets an order that brings additional revenue of Rs 3,000. The
cost of production from this order is:
Rs.
Labour 800
Materials 1,300
Overheads 1,000
Selling and administration expenses 700
Full cost 3,800
At a glance, the order appears to be unprofitable. But suppose the firm has
some idle capacity that can be utilised to produce output for new order. There
may be more efficient use of existing labour and no additional selling and
administration expenses to be incurred. Then the incremental cost to accept the
order will be:
Rs.
Labour 600
Materials 1,000
Overheads 800
Total incremental cost 2,400
Incremental reasoning shows that the firm would earn a net profit of Rs 600
(Rs 3,000 – 2,400), though initially it appeared to result in a loss of Rs 800.
The order should be accepted.
A simple situation in everyday life provides an example of incremental analysis.
Consider a worker leaving work to travel home. Groceries are required and can
be purchased at slightly higher prices at a store on the way from the work place
to the home, or at lower prices by driving to a store 3 miles (4.82 km) from
home. The worker decides to purchase the groceries on the way home since no
incremental travel costs are involved, and the incremental difference in grocery
prices will be less than the value the worker places on the time and other costs
required to drive to the more distant store.
Principle of time perspective:
“a decision by the firm should take into account of both short-run and long-
run effects on revenues and cost & maintain the right balance between the
long run and short run.
According to the principle of time perspective, a manger/decision maker should
give due emphasis, both to short-term and long-term impact of his decisions,
giving apt significance to the different time periods before reaching any
decision. Short-run refers to a time period in which some factors are fixed
while others are variable. The production can be increased by increasing the
quantity of variable factors.

While long-run is a time period in which all factors of production can become
variable. Entry and exit of seller firms can take place easily. From consumers
point of view, short-run refers to a period in which they respond to the changes
in price, given the taste and preferences of the consumers, while long-run is a
time period in which the consumers have enough time to respond to price
changes by varying their tastes and preferences.

Eg: ABC is a firm engaged in continuous production of X commodities (long

run). In the production process, it is having daily an ideal time (free time) for
few hours. In that ideal time, firm can take an order for manufacturing other
similar goods instead of wasting time. By manufacturing goods in the ideal
time firm does not incur any extra fixed cost like (salaries, wages and rent and)
because it is constant. So the fixed cost is absent in the production which is
done in the ideal time. Generally in production of goods, fixed and variable
cost (raw material & labour) is present. However, here the production made in
the ideal time, fixed cost is absent. This shows the cost is reduced in production
that is made in the ideal time. Investment made in the business can also be
recovered very quickly and in short time.
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 unit (Rs.5000/- for the lot)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”.
Here the principle of time perspective applies, where maintains right balance
between long run and short-run markets.
Discounting principle explains about the comparison of money value in
present and future time.
Example:
If person is given option to take 100/- as a gift for today.
or
If person is given option to take 100/- as a gift after one month.
Normally a person chooses first offer only. Why because “today rupee is
having more worth than tomorrows rupee”

Application of discounting principle in business:

Example 1:
In the business, everybody prefers to do cash sale only rather than the credit
sale and even they are ready to give cash discount for cash sale. The reason is
we will get a rupee today and today’s rupee is more valuable than the
tomorrow’s rupee. But In credit sale we will get rupee tomorrow or in the
future time and nobody give the discount for credit sale.

Example 2:
We commonly see bank and postal departments adverting that they will give
12% interest for every year on bank deposits what we have invested with them.
With this 12% interest for one year, if we want to get 1-lakh rupees after one
year, how much we should deposit at present? This question is answered by
discounting principle.
In the future if we want to earn 100000/- how much we should invest at present.
Example in the bank (100/- @ 12% interest rate of one year)

In this case we should invest at present 92.59 @ 8% interest for one year to get
100/- for the next year.
How to estimate the purchasing value of the Rupee
How often have we heard our grandparents reminisce about the good old days
when things were so much cheaper? Everything seems to have been available
at a fraction of what it costs today, be it rice, potatoes, mangoes, petrol or
utensils. A kilo of sugar that could have been bought for Rs 2 in the 1970's
currently costs Rs 40, while a dozen bananas that you could have bought for
just Rs 10 about 20 years ago, will now cost you Rs 35. The quantity of a
commodity that a rupee used to buy years ago has contracted. In other words,
the rupee has lost its purchasing power. The reason for this loss is largely
macro-economic and linked to aggregate demand and supply dynamics,
government borrowings, exchange rate and interest rates. Typically, the rupee
loses its purchasing power when there is a general increase in the economy's
price level, technically termed as inflation. Inflation is not only a cause of
concern for the RBI and the government, it also severely impacts the value of
the investment portfolios and can upset any deferred purchase plans. For
example, in 2010, painting your house cost Rs 40,000. You deferred the plan
for a year and kept the amount in your savings account. In 2010-11, inflation
went up by 9.6% (on an average). So, the expense of the paint job increased to
Rs 43,825, but you only have Rs 41,400 in your bank account. Due to the fall
in the value of money, you will now need to cough up an extra Rs 2,425 for the
same work. Let us look at how you can estimate the purchasing power of
money. This concept rests on the theory of discounting, which is the reverse of
the compounding theory. In discounting, the amount receivable at some future
date is worked back to the current time period. The future amount is discounted
to the current period using a rate known as the discounted yield. Say, someone
promises to pay you Rs 1,000 a year from now. The interest rate offered by
your bank is 9%. Using the bank's interest rate as the discounted yield, you can
work out the current or present value of Rs 1,000, which comes out to be Rs
917.43. If, instead, you receive Rs 1,000 now, you could invest it at 9% and
after one year, you will receive Rs 1,090.
The concept has varied applications in investment and financial planning. It is
used by banks for determining the home loan EMIs and is also used by
financial planners for estimating the returns from money back insurance
policies, mutual fund SIPs and bond yields. Looking at the value of the rupee,
the rate of inflation prevailing in the economy is used as the discounted yield
for determining its purchasing power. The formula for discounting is given
above.
Over the past 21 years, the inflation rate in the country (as measured by the
WPI index) has averaged 6.07% annually. Here's how the purchasing value of
Rs 100 has changed over these years. In the above formula, 'CV' is Rs 100, 'i' is
equal to 6.07% and 'n' equals 21. So, the value of 'RV' will compute to Rs
29.01. This means that what Rs 29 used to buy in 1990-91 will now cost Rs
100. If the above equation appears complicated.
Equi-marginal principle is one of the widely used concepts in managerial
economics. This principle is also known the principle of maximum satisfaction
- by allocating available resource to get optimum benefit . This principle
provides a basis for maximum utilization of all the inputs of a firm so as to
maximize the profitability.
In the practical world, a person may purchase more then one commodity. Let
us assume that a consumer purchases two goods A and B. How does a
consumer spend his fixed income in purchasing two goods in order to
maximize his total utility? The law of equi-marginal utility tells us the way
how a person maximizes his total utility.
The equi-marginal principle can also be applied in time allocation problems
such as studying for examinations. Suppose you have 3 examinations tomorrow
and you only have 9 hours to study today (a usual case for students who cram
during exams!). The subjects covered are Economics, English and Mathematics.
Your objective is to maximize the average of your grades in these 3 subjects
with your limited study time. In other words, how should you allocate your 6
hours of study time such that the marginal grade (or additional grade) from the
last hour of studying spent in one subject is just equal to the marginal grade
from the last hour of studying spent in any of the other subjects? If you answer,
“I’ll divide my lime equally among the 3 subjects", that may not really be the
most practical (or if you prefer, strategic) thing to do. Why?

Because there will always be difficult and easy subjects for you such that you
will have to spend longer hours for a difficult subject while it will take you
only a few minutes to study for an easy one. Of course, the perceived level of
difficulty among subjects is relative. The marginal grade may be represented by
the additional grade that you expect to get in each of the subjects from each
additional time that you spend studying for each and the level of difficulty of
the subject concerned.
The equi-marginal principle can be applied in different areas of management. It
is used in budgeting. The objective is to allocate resources where hey are most
productive. It can be used for eliminating waste in useless activities. It can be
applied in any discussion of budgeting. The management can accept
investments with high rates of return so as to ensure optimum allocation of
capital resources. 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.
The equi-marginal principle may also be applied in allocating research
expenditures.
Rule:
This principle suggests that available resources (inputs) should be so allocated
between the alternative options that the marginal productivity gains (MP) from
the various activities are equalized.
Definitions
In the words of Ferguson, "Law of equi-marginal utility states that to
maximise utility, consumers way allocate their limited incomes among goods
and services in such a way that the marginal utilities per dollar (rupee) of
expenditure on the last unit of each good purchased will be equal"
According to Marshall, "if a person has a thing which he can put to several
uses, he will distribute it among these uses in such a way that it has the same
marginal utility in all"
Lipsey is of the view that, "The consumer maximising his utility wilt so
allocate expenditure between commodities that the utility derived from the last
unit of money spent on each is equal"
Example: students allocating limited available days for existing subjects during
examinations for getting best percentage. 14 days to go for examinations and
having 7 subjects. Students may not always allot 2 days for each subject, they
may allot more days for hard subject and less days for easy subject to maintain
good percentage.
Let us consider the meaning of the term marginal'. Marginal unit is one which
marks an addition to the total number of units. For example, a firm employing
ten workers will say that the tenth worker is the marginal worker. A firm
producing one thousand units of its product may decide to produce ten more
units and the tenth unit over and above the 1009 units becomes the marginal
unit. When we say that the decision is taken at the margin we mean the
following : the wage-rate has got to be equal to the productivity of the marginal
worker, which means that no worker gets more than what the marginal worker
produces. Similarly, the price of the product has got to be equal to the marginal
utility derived by consuming that product. Is it profitable to bring one more
acre of land under cultivation ? The answer is : So long as every additional unit
of land produces more than enough to meet the cost, the process of adding
acres under cultivation would continue. The process would stop at that point
were the value of the product of the marginal acre of land produces just equal
to cover the cost of production.
Example:
Equi-marginal principle is applied in the allocation of the resource in the way
of production. Example a farmer is having different four agricultural farms like
1. Paddy
2. Mangoes
3. Sugar cane
4. Corns.
The above four agricultural farms are in the total 80 acres, each farm in the 20
acres, all together 80 acres. The farmer is having limited 80 employees with
him for employing in the four farms for production. In general, 80 employees
are divided and employed for four farms evenly as each farm will be allotted
with 20 employees. However, in reality there is no need to allot 20 employees
for each farm, because mango farm need less number of employees, whereas
paddy farm needs more number of employees. Sugarcane and corn farms
require average number of employees. Like shown below

The above table reveals the allocation of the resources (labour) available with a
farmer according to the level of output or production nature and requirement.