Fundamental Principles of

Economics
Incremental , Marginal, Opportunity Cost, Discounting , concept of
Time Perspective, Equi Marginal Principle, utility Analysis
Teaching Pedagogy

 Class lectures
 Case study discussion
 Discussion & Debates in class
 student Presentation
 Domain Quiz
 Tutorials
 Video( based on relevant topics)
 Assignments
Incremental principle or Marginal principle

 Most significant in taking production decisions.

 Useful in the theory of consumption, pricing and distribution.
 Incremental analysis involves estimating the impact of decision alternative on
cost and revenue.
 Involves 2 components: 1. Marginal or incremental cost 2. Marginal or
incremental Revenue.
 Incremental cost is defined as the change in the total cost as a result of change in the level of
output or investment.
 Incremental revenue is the change in total revenue resulting from a change in the level of output,
prices etc.
 A manager always determine the worth of a decision on the basis of the criteria that IR>IC
 A manager decision is profitable if,
 It increases revenue more than it increases cost
 It reduces some cost more than it increases others
 It increases some resources more than it decreases others
 It decreases cost more than it decreases revenues.
Incremental Revenue and incremental cost

 IR = A TR / AQ
 A- change , TR- Total Revenue, Q- Total quantity of output

 IC= ATC/AQ
 A- change, TC- Total Cost , Q- quantity of output

 Decision Choice: IR>IC

Difference between marginal and incremental concepts

 Suppose 100 workers on a land area of 1 hectare can produce 200 tonnes of wheat.
If one more worker is employed, total production increases to 202 tonnes. Hence
the marginal production due to 1 more labour employed is 2 tonnes.
 But , in real life factor production may not be properly divisible. If 110 workers are
employed , total production is 210 tonnes. Now the incremental output is 10
tonnes. Hence, the average incremental output is 1 tonne per worker whereas, in
first case marginal incremental was 2 tonne.
 The marginal analysis unit change is important but in incremental analysis bulk
change is important.
 Eg: a builder may not change 1 labourer at a time but many of them together.
Example

 Suppose an automobile firms adopt a new factor plant to increase its output. This
may involve a rise in its total cost by 20% against increase in output by 10%.
 Incremental cost = 20%/10%= 2%

 Incremental revenue = 30%/10%= 3%

 Profitable decision to undertake new investment (IR>IC)

Difference Between Marginal and Incremental

Marginal concept Incremental concept

 Expressed in terms of unit change  Expressed in terms of bulk change

 Depends upon single variable

function i.e revenue depends upon  Assumes multi variable function
output
 Marginal analysis is more specific  Incremental is more general.
 All marginal concepts are
incremental
 All incremental need not to be marginal
concepts.
Precaution in Applying Marginal Principle

 A manager ought to pay special attention to the time horizon relevant to the
problem .
 If the firm is concerned with longer period , use of MR and MC will not be
appropriate.
 Then the firm has to take account of full cost permit of product principle.

 Marginal analysis is only relevant for shorter period.

2. Opportunity cost Principle

 The alternative or opportunity cost of producing one unit of commodity X is the

amount of commodity Y , that must be scarified in order to use the resources to
produce X rather than Y
 Eg: a Farmer who is producing wheat can also produce potatoes with the same
factor, the opportunity cost of wheat is the amount of potatoes given up.

 Opportunity cost of anything is the next best alternative that could be produced
instead by the same factors, costing the same amount of money.
2. Opportunity cost principle

 Opportunity cost also knows as cost of scarified alternatives

 Examples are :
 OC of funds employed in one own business is the interest that could be earned on the
funds.
 OC of the time of an entrepreneur devotes to his own business is the salary he could earn
by seeking employment.
 OC of using a machine to produce one product is the earning forgone which would have
been possible from other products.
 OC of holding 600 as cash in hand for 1 year is the 7 % rate of interest which would have
been earned.
Point to note

 OC of a given amount of money can never be zero

 Decision making involves choices and choices must involve cost calculations.
 OC may be either real or monetary
 OC can be quantifiable or non quantifiable.

 opportunity cost with Production possibility curve

Production possibility curve

 Acc to samuelson, PPC illustrates the popular definition of economics- problem

of choosing from among scarce or limited resources, having alternative
applicability's in order to achieve the best ends.
 Supported with graphical representation.
 Assumptions :
 The productive resources such as labour, capital etc are fixed in supply.
 The technique of production is given – it remain constant
 There is full employment condition of economy’s equilibrium.
Relevance of opportunity cost.

 In everyday life, we apply the notion of opportunity cost.

 When a person devotes his entire time in business , he hopes hw will earn at
least as much as he can by working some where else.

 Every decision In business takes into account the cost of opportunities forgone.
 Managerial decision must be based on clear understanding of the cost of
alternatives decision and how relevant these costs are in a given situation.
3. Time perspective principles

 A manager must take into consideration of time element for every decision
making exercise.
 Time is divided in to 2 : short run and long run
 Short run: volume of O/P cannot be changed by altering the size of the firm.
 Long run: where all the factors become variable.
 A decision should take into account both short run and long run effects on
revenue and cost and maintain a right balance between long term and short term
perspectives.
4. Discounting principle

 If a decision affects cost and revenue at future dates, it is necessary to discount

those cost and revenue to present values before a valid comparison of alternative
is possible.
 Discounting is important because a rupee tomorrow is worth less than a rupee
today.
 Eg: suppose a person is offered to have a gift of rs. 100 today or Rs. 100
tomorrow,
 He will choose Rs. 100 today .
Reason ??
Reason

 1. The future is uncertain

 2. even if he is sure of getting the amount in future, today 100 can be invested so
as to earn interest. Say 5 % , Rs. 100 today will become Rs. 105 Tomorrow.
 So we can say that, 100 1 year later is not equal to 100 today but less than that.
How much money today will be equal to 100 one year
hence. ??

 Suppose rate of interest is 5 percent.

 V= Rs. 100/1+I
 Or
 V= Rs 100/ 1+ 0.5 = Rs. 95.24
 The same analysis can be extended for period of 2 year
 V= 100/(1+i)²
 Or V= Rn/(1+i)ⁿ
 In most of the managerial decision where monetary cost and revenue is involved ,
discounting is essential for efficient Managerial decisions.
5. Equi Marginal Principle

 Deals with allocation of available resources among alternative activities

 A rational decision maker would allocate its resources in such a way that the ratio of
marginal returns and marginal cost of various uses of a given resource is the same.
 Eg: a consumer who wishes to maximize its utility would allocate his consumption budget on
goods and services such that
 MU1/MC1=MU2/MC2=………….Mun/MCn
 Or
 A producer who wants to maximize his gains would allocate resources in such a manner that
 MR1/MC1= MR2/MC2………..= MRn/MCn
consumer behavior: Marshallian Utility Analysis
consumer behavior: Marshallian Utility Analysis

 Why does a consumer demand goods and services?

 How should a consumer spend his limited income on different goods and service
so that he can maximize his satisfaction?
Utility

 Utility is the want satisfying power of a commodity

 Utility is the psychological felling of satisfaction , pleasure, happiness that is

derived by a consumer from the use of commodity.

 Concept is subjective and will differ from place to place, time to time, person to
person.
Types of utility

 Cardinal utility :
 According to classical economist, utility can be measured in cardinal numbers
like 1,2,3 etc.

 Ordinal utility :
 According to modern economist, utility is not quantitatively measurable in
absolute terms. It can be expressed in terms of preferences. Like first , second,
more than ,less than etc. Also known as indifference curve analysis.
3 concepts of utility

 Initial utility
 Marginal utility
 Total utility
 Initial utility : the utility derived from the first unit of commodity.
 Eg: first loaf of bread,
 Always positive.
 Total utility :
 Derived from the total number of units of a commodity consumed by him.
 TUn = U1+U2+U3+U4……….Un
 Marginal utility :
 Addition made to total utility by consuming one more unit of the commodity.
 Eg: 4 loafs of bread gives total utility 10+9+7+4=30
 3 loafs of bread gives 10+9+7=26 units
 Marginal utility from 1 additional unit is 30-26=4 units
Relationship between TU and MU( graphical representation)

 When TU increases , MU is positive

 When TU is maximum ( point of saturation), MU is 0
 When TU decreases, MU become negative .
 Marginal utility is of 3 types:
 Positive marginal utility
 Zero marginal utility
 Negative marginal utility.
Tabular and graphical relationship between MU and TU

Units of good consumed Marginal utility (Mu) Total utility (TU)

1 6 6
2 4 10
3 2 12
4 0 12
5 -2 10
6 -4 6
Assumptions of utility analysis

 Cardinal measurement of utility (quantifiable entity not qualitative)

 Utility is additive ( not only measurable but also additive- Total utility)
 Independent utilities ( 1 person utility is not affected by other person utility)
 Marginal utility of money remains the same
 Introspection (assumes from you own experiences)
Laws of utility analysis

 Law of diminishing marginal utility

 Psychological fact that when a consumer gets more and more of a commodity ,
during a particular time, the utility from the successive units will diminish
Pieces of bread(toasts) Marginal utility
1 8
2 4
3 2
4 0
5 -2
 law of Equi marginal utility
 According to this law, a consumer will be at equilibrium when , Mux/Px= Muy/Py
i.e the ratio of marginal utilities and prices are equalized in purchasing various
commodities.
 Now suppose, the price of X is reduced (falls), then the equilibrium condition is
disturbed and Mux/Px>Muy/PY.
 In order to attain equilibrium again, the consumer will have to reduce his
marginal utility (MU) of X and increase the marginal utility of Y so that both the
ratios are marginalized.
 This type of consumer behavior with the price change is technically expressed by
Marshall as Substitution effect and price effect.
Limitations of Marshallian Approach

 Untenable cardinal measurement of utility

 Wrong conception of additive utility
 Homogeneity assumption is unrealistic
 Separate measurement of utility
 Constancy of marginal utility of money
 Inapplicable in case of indivisible or bulky goods
 No empirical test( based on introspective approach)