Module 1

Foundations of Managerial
Economics
Economics Is The Art Of Making The Most
Of Life - GB SHAW
What is Economics
Scarcity – a basic human dilemma
◦ –Limited resources vs. unlimited wants
◦ –The human condition requires making choices
 What is Economics
The term economics comes from the Greek word oikos (house) nomos (custom or
law)
Adam Smith – father of economics
–He saw economic as “ an enquiry into the nature and causes of the wealth of
nations”
Alfred Marshall
–Economics is the study of mankind in the everyday business of life

Economics is defined as a body of knowledge or study that discusses how a society tries
to solve the human problems of unlimited wants and scarce resources
Introduction
Countless firms have used the well-established principles of managerial economics to improve
their profitability.
Managerial economics draws on economic analysis for such concepts as
◦ Cost
◦ Demand
◦ Profit
◦ Competition

It attempts to bridge the gap between the purely analytical problems that intrigue many
economic theorists and the day-to-day decisions that managers must face.
Managerial Economics as a tool for solving Management Decision
Problems
Introduction…
The subject offers powerful tools and techniques for managerial policy-making.
An integration of economic theory and tools of decision sciences works successfully in optimal
decision-making in face of constraints.
A study of managerial economics:
 enriches the analytical skills,
 helps in the logical structuring of problems,
 provides adequate solution to the economic problems
Scope of Managerial Economics
1. Resource allocation:
◦ Scarce resources have to be used with utmost efficiency to get optimal results.
◦ These include production programming, problem of transportation, etc.

2. Inventory and queuing problem:

◦ Inventory problems involve decisions about holding of optimal levels of stocks of raw materials and finished goods over a period.
These decisions are taken by considering demand and supply conditions.
◦ Queuing problems involve decisions about installation of additional machines or hiring of extra labour in order to balance the
business lost by not undertaking these activities.

3. Pricing problems:
◦ Fixing prices for the products of the firm is an important part of the decision making process.
◦ Pricing problems involve decisions regarding various methods of pricing to be adopted.

4. Investment problems:
◦ Forward planning involves investment problems.
◦ These are problems of allocating scarce resources over time. For example, investing in new plants, how much to invest, sources of
funds, etc.
 Study of managerial economics essentially involves the analysis of certain major subjects like:
1. Demand analysis and methods of forecasting
2. Cost analysis
3. Pricing theory and policies
4. Profit analysis with special reference to break-even point
5. Capital budgeting for investment decisions
6. The business firm and objectives
7. Competition.
Types of Economic Analysis
Micro and Macro
Positive and normative.
Short run and long run.
Partial and general equilibrium.
Micro And Macroeconomics
MICRO ECONOMICS
– It looks at the smaller picture of the economy.
– It is the study of behavior of smaller economic units such as that an individual
consumer, producer/seller or a product.
– It focuses on the basic theory of supply and demand in individual markets.
(Example- automobiles, FMCG, Telecommunication etc)
– It deals with the how individual businesses decide how much to produce and what
price to sell it and how individual consumer decide how much to buy.
– It analysis the market behavior of individual consumers and firm and their decision
making.
 Micro And Macroeconomics …
MACRO ECONOMICS
– It is the branch of economics that deals with the study of aggregates.
– Study the industry as a unit and not the firm.
– It talks about aggregate demand and aggregate supply
– It talks about national income, GDP,GNP, inflation, employment etc.

 Microeconomics deals at the firm’s level and takes into consideration the decision-making power of
individual units, whereas
 Macroeconomics deals with the economy level and takes into consideration the impact of government
policies on the aggregates like national income and employment.

Micro and Macro economics complement each other

Positive and Normative Statements
POSITIVE STATEMENTS
–These are factual by nature, whose truth or falsehood can be verified by empirical study or logic.

NORMATIVE STATEMENTS
–They involve some degree of value judgment and cannot be verified by empirical study or logic

E.g. (Identify the statements)

1. The distribution of income in India is unequal.
2. The distribution of income in India should be equal.
Positive and Normative Economics
POSITIVE ECONOMICS (“what is”)
– It establishes a relationship between cause and effect.
– It analysis problems on the basis of facts.
– In simple words, it studies the world as it is and is as such devoid of (economic) value
judgments

NORMATIVE ECONOMICS (“what ought to be”)

– It concerned with the questions involving value judgment.
– It incorporates the value judgments about what the economy should be like.
– It looks at the desirability of certain aspects of the economy.
Positive and Normative
Economics…
For example, a positive economic theory
might describe the probable effect of an
increase in price of petroleum on the price
of cars, but it would not provide any
instruction on what policy should be
followed.

For example for normative economics,

inflation as better than deflation,
redistribution of wealth in the economy,
etc.
Short Run And Long Run
Marshall gave the contribution of different period time in market analysis.
He defined the periods in market as a market period.
Short Run(less than a Year)
– It is a time period not enough for consumers and producers to adjust completely to
any new situation.
– In production decisions short run is a period when it may not be possible to change
all the inputs.
– In this some input are fixed others are variable.
–Manager has to select different levels of variable input to combine with the fixed
input in order to optimize the level of production
Short Run And Long Run…
Long Run (Planning Horizon)
– It is a time period long enough for consumers and producers to adjust to any situation.
– All inputs can be varied.
– Managerial economist deals with decisions whether to expand capacity , change product
lines etc.
– Time period – 5-6 years/ even as high as 20 years
Partial and General Equilibrium
EQUILIBRIUM
– It is a state of balance that occur in a model.
Partial Equilibrium Analysis
– It studies the internal outcome of any policy action in a single market only.
– The effects are examined only in the markets which is directly affected not on other
markets.
– We refer to partial equilibrium analysis when a single firm or a single consumer is in
equilibrium, other firms in industry may not be in equilibrium.
Partial and General Equilibrium…
General Equilibrium Analysis
– It is the branch of economics that seeks to explain economic phenomena like
production, consumption and prices in a economy as whole.
– It tries to give an understanding of the whole economy by looking at the
macro perspective.
– General equilibrium is the state in which all the industries in an economy are
in equilibrium; as a corollary it is implied that all the firms in an industry are in
equilibrium.
Kinds of Economic Decisions
An analysis of scarcity of resources and choice making poses the basic questions:

1. What to produce and how much to produce?

2. How to produce?
3. For whom to produce?
4. Are Resources Used Economically?
5. Are resources fully employed?
6. Is the economy growing?
What to Produce? The Coca Cola Way
- Example
Marc Mathieu, Senior VP Global Brand Marketing & Creative Excellence, The Coca Cola
Company, in conversation with S. Mukherjee and S. Dobhai says that as a beverage company
Coca Cola aims to offer all possible alternatives by spending lot of time in understanding
consumer’s lifestyle and needs. It recognises that there are moments when people want to be
more focused on nutritional values and there are moments when one requires mental recharge;
sometime one wants vitality and energy boost. Therefore, the company aims to cover and cater
to these different needs through its beverage portfolio. The portfolio claims to offer an
appropriate level of sweetness and functional benefi ts along with right packaging and
communication.
Source: Economic Times, 9/01/2008
Managerial Economics
Managerial economics is a means to an end to
managers in any business in terms of finding the
most efficient way of allocating scarce
organizational resources and reaching stated
objectives
Definition- Managerial Economics
“Managerial economics refers to the application of economic theory and the tools of analysis of
decision science to examine how an organisation can achieve its objectives most effectively.” -
Salvatore
“Managerial economics is the study of allocation of the limited resources available to a firm or other
unit of management among the various possible activities of that unit.”
- Henry and Haynes
“Managerial economics applies economic theory and methods to business and administrative
decision-making.”
- Pappas and Hirschey
“Managerial economics is the application of economic principles and methodologies to the decision-
making process within the firm or organisation.”
- Douglas
Managerial Economics- Micro Vs.
Macro
 Managerial economics is applied micro economics to a significant extent
though it draws extensively from macroeconomics theory.

– Example: Managerial Economics draws demand analysis, cost and production

analysis, pricing and output decision from micro economics. Where it also
derives market intelligence from the knowledge of national Income (GDP, GNP, ),
inflation and stages of recession and expansion, which are subject matter of
macroeconomics
 Managerial Economics- Normative Bias
•Managerial economics has a normative bias stating what firms should do, in order to reach
certain objectives.
•Economic issues confronting managers would often involve value judgments.
•In managerial situations one has to take decisions which will affect organizations future
therefore managers cannot be simply content with being factual
Example: The manager of a soft drinks company may be confronted with a choice of
whether or not to advertise for the product. Would the manager go for advertising simply
by following the rival companies? Or would the manager judge whether such advertising
would have any impact on the consumers? Managerial economics decides on whether or
not the probable outcome of a managerial decision is desirable, and whether or not the
managers should pursue courses of action that would lead to such outcomes. Hence, it is
basically normative in nature.
MANAGERIAL ECONOMICS –
PARTIAL EQUILIBRIUM
Managerial economics deals with partial equilibrium analysis with focus on
equilibrium of a firm or an industry, not the economy.
Decision making of managers would relate to the equilibrium of particular
firm.
Economic Principles Relevant to
Managerial Decisions
• The key economic concepts and principles that constitute the broad framework of managerial
economics are:
– Concept of scarcity
– Concept of opportunity cost
– PPF – production possibilities curves
– Concept of margin or increment
– Discounting principle
• According to the above economic principles the decision are taken by managers in their
operating environment.
 Concept of Scarcity
• The starting point of any economic analysis is the existence of human wants (unlimited).

Resources Demand for Resources

Problem of Scarcity

•Human wants are unlimited, but human capacity to satisfy such wants is limited.
• All desirable things (resources) are short in supply compare to our needs (demand). The decision
should made to optimally utilize them.
• Any economic problem consists of making decisions regarding the ends to be pursued and the goods to
be used for achievement of such ends.
Concept of Opportunity Cost
The managerial economist has to make rational choices in all aspects of
business by sacrificing some of the alternatives, since resources are scarce and
wants are unlimited.
Opportunity cost is the benefit forgone from the next best alternative that is
not selected.
Production Possibility Curve
• The Production Possibility Curve (PPC) also known as Production Possibility Frontier (PPF) or
Transformation Curve
• It is a graph that shows the different combinations of the quantities of two goods that can be
produced (or consumed) in an economy at any point of time, subject to limited availability of
resources.
• It also depicts the trade off between any two items produced (or consumed).
• In other words, PPC shows that if we want to have more of one good, we must have less of
the other good, due to limited availability of resources.
• Other than representing the aspect of opportunity cost and measuring it, PPC also highlights
the significance of scarcity of resources and the need to use them judiciously.
Production Possibility Curve
The concept of PPC used in both micro and macro economics :
•PPC for individual firm/consumer-micro
•PPC for entire society – macro
Production Possibility Frontiers -
Individual
PPC - Assumptions and Explanation
• What ever is earned by individual is spent.
•At point P on AB shows
◦ At given income individual can buy Fp units of food and Cp units of clothing.

•If the individual wants to have any more clothing at same level of income they needs to
sacrifice some units of food.
•That bring individual to point Q
•Fq < Fp and Cq>Cp
•M – not attainable it represents combination of commodities beyond income.
•N - not desirable combination of commodity that would not maximally utilize the individuals
income.
Production Possibility Frontiers - Society
Production Possibility Frontiers –
Society…
Production Possibility Frontiers –
Society…
•Assumptions
– Factors of production are fixed in supply
– Technology remains same
•No ‘ideal’ point on the curve
•Any point inside the curve – suggests resources are not being utilized efficiently
•Any point outside the curve – not attainable with the current level of resources
•Useful to demonstrate economic growth and opportunity cost
Concept of Margin and Increment
• Marginal analysis is one of the cornerstones of economic theory.
• The concept of marginality deals with a unit increase in cost or revenue or
utility.
• Marginal cost
◦ It is the change in total cost /total revenue/total utility due to unit change in output.
◦ Marginal cost/marginal revenue/marginal utility is the total cost /total revenue/total utility
of the last (nth) unit (of output).
Concept of Margin and Increment…
• However, there is an inherent problem with the marginal concept and that is, in
reality variables may not be subject to such unit change as explained earlier.
• The incremental concept is applied usually when the changes are not
necessarily in terms of a single unit, but in bulk.
• In such a case, the additional revenue earned is termed as “incremental
revenue”.
• If a decision to increase revenue also entails an increase in costs, then the
incremental concept would tell whether the decision is right (if the increment in
cost is less than incremental revenue) or wrong.
Concept of Margin and Increment…
For example, an increase in the sales of a firm due to introduction of
online selling and additional costs of launching the online selling
mechanism would be termed as “incremental revenue” and
“incremental costs” respectively. If the former exceeds the latter, we
can infer that the decision of introducing the online mechanism is
right.
Discounting Principle
 The core of discounting principle is that a rupee in hand today is worth more
than a rupee received tomorrow
 This principle refers to time value of money

Why do businesses need to bother about discounting?

Discounting Principle…
 Businesses need to bother about discounting because most
business decisions relate to outflow and inflow of money and
resources that take place at different points of time.
Theory of Firm
 A firm is an entity that
• draws various types of factors of production in different amounts from the economy,
• then converts them into desirable output(s), through a process with the help of suitable technology.

 Five factors of Production are:

Land Labour Capital

Enterprise Organization
Theory of Firm…
 Factors of production cannot produce unless they are given proper direction and a system to
operate in.
 The process of identifying the potential sources of the factors such as land, labour and capital,
collecting them in required quantities and assigning them specific tasks as per their skills is the
subject matter of organisation.
 Using these factors of production for economic activities, without any certainty of returns is
the function of enterprise, or the entrepreneur
Theory of Firm- Forms of Ownership
Objectives of Firm
1. Profit Maximisation Theory:
◦ According to profit maximisation theory, objective of business is generation of the largest amount of profit.

Profit = Total Revenue – Total Cost

 Certain pertinent questions arise in accepting profit maximisation as the objective of the firm:

• which measure of profit to consider among gross profit, net profit, net profit after tax, and net profit before tax?
• which period of time to take into account among current year, next year, next five years, and next 10 years?
.
.
.
Objectives of Firm…
2. Baumol’s Theory of Sales Revenue Maximisation

◦ Raised questions on validity of profit maximisation as an objective of the firm

◦ Stressed that in competitive markets, firms would rather aim at maximising revenue, through maximization of
sales
◦ Emphasized that sales volumes, and not profit volumes, determine market leadership in competition
◦ Emphasized that in large organizations, management is separate from owners, hence there will be a
dichotomy of managers’ goals and owners’ goals
◦ Management is more interested in maximising sales, with a constraint of minimum profit

Sales maximisation theory asserts that managers attempt to maximise the firm’s
total revenue, instead of profits.
Objectives of Firm…
3. Marris’ Hypothesis of Maximisation of Growth Rate
 Marris proposed that
• owners (shareholders) aim at profits and market share
• managers aim at better salary, job security and growth

 These two sets of goals can be achieved by maximising balanced growth of the firm (G), which
is dependent on:
• the growth rate of demand for the firm’s products (GD) and
• growth rate of capital supply to the firm (GC)

 Hence, growth rate of the firm is balanced when the demand for its product and the capital
supply to the firm grow at the same rate.
Objectives of Firm…
3. Marris’ Hypothesis of Maximisation of Growth Rate…

Two constraints firms face in attaining the objective of maximisation of balanced

growth:
 Managerial Constraint
 Financial Constraint
◦ moderate debt equity ratio
◦ moderate liquidity ratio
◦ moderate retained profit ratio
Objectives of Firm…
4. Williamson’s Model of Managerial Utility Function
 Oliver Williamson’s model is a combination of the objectives of profit
maximisation and growth maximization
 As per Model of Managerial Utility Function, managers apply their
discretionary power to maximise their own utility function, with the constraint
of maintaining minimum profit to satisfy shareholders.
The utility function of managers, namely , is dependent upon
• managers’ salary (measurable)
• job security, power, status, professional satisfaction (all non measurable); and the
power to influence firm’s objectives
Objectives of Firm…
4. Williamson’s Model of Managerial Utility Function…
Williamson took measurable proxy variables like perks of the manager, office facilities like
company car, and slack payments like a luxurious environment in the office, and expenditure that
takes place at the discretion of the manager, heading a large pool of workers, which is directly
related to his power and status.
Objectives of Firm…
4. Williamson’s Model of Managerial Utility Function…

It is easy to understand that since S is represented in terms of salary and other benefits and is
actually an item of expenditure, it has negative relation with profit.
 Managers’ interest is in increasing their salary; hence their goal is to maximise . At the same
time, they are aware that they have to keep their shareholders happy; therefore they try to find
an optimum combination of S and
Objectives of Firm…
5. Behavioural Theories
Behavioural theories propose that firms aim at satisficing behaviour, rather than maximisation.

Behavioural
Models
Simon’s
satisficing
Model

Model by
Cyert and
March
Objectives of Firm…
5. Behavioural Theories…
 According to Herbert Simon’s satisficing model, firm has to operate under “bounded
rationality” and can only aim at achieving a satisfactory level of profit, sales and growth.
According to his Model, the biggest challenge before modern businesses is lack of full
information and uncertainty about future.

According to the Model by Cyert and March, firms need to have multi goal and multi decision-
making orientation.
To meet the objective of satisficing behavior, managers form an aspiration level on basis of
their past experience, past performance of the firm, performance of other similar firms, and
future expectations.
Objectives of Firm…
5. Behavioural Theories…
Criticisms
◦ It lacks objectivity and cannot be used to predict a firm’s future direction
◦ It fails to recognize interdependence of firms
◦ It may not even work under dynamic business environments