Chapter 1

Basic Concepts and

Principles
Lecture plan
 Objectives
 What is Economics?
 Basic Assumptions
 Types of Economic Analysis
 Managerial Economics
 Managerial Decisions
 Economic Principles Relevant to Managerial Decisions
 Production Possibilities Curve
 Managerial Economics and Functions of Management
 Relationship with Other Disciplines
 Summary
Objectives

 To introduce key economic concepts like scarcity,

rationality, equilibrium, time perspective and
opportunity cost.
 To explain the basic difference between
microeconomics and macroeconomics.
 To help the reader analyze how decisions are made
about what, how and for whom to produce.
 To define managerial economics and demonstrate its
importance in managerial decision making.
 To discuss the scope of managerial economics and
its relationship with various other disciplines and
functional areas.
What is Economics?
 Discusses how a society tries to solve the human
problems of unlimited wants and scarce resources.
 Scientific study of the choices made by individuals and
societies with regard to the alternative uses of scarce
resources employed to satisfy wants.
 Theoretical aspect and an applied science in its practical
aspects.
 Not an exact science; An “art” as well
 A social science
 Deals with the society as a whole and human behaviour in
particular
 Studies the production, distribution, and consumption of
goods and services.
 A science in its methodology, and art in its application.
Basic Assumptions
 Ceteris Paribus
 Latin phrase
 “With other things (being) the same” or “all other things
being equal”.
 Rationality
 Consumers maximize utility subject to given money
income.
 Producers maximize profit subject to given resources
or minimize cost subject to target return.
 Types of Economic Analysis
 Micro and Macro
 Microeconomics (“micro” meaning small): study of
the behaviour of small economic units
 An individual consumer, a seller/ a producer/ a
firm, or a product.
 Focus on basic theories of supply and demand in
individual markets
 Macroeconomics (“macro” meaning large):
study of aggregates.
 Industry as a unit, and not the firm.
 Focus on aggregate demand and aggregate
supply, national income, employment, inflation,
etc.
Types of Economic Analysis

 Positive and Normative

 Positive economics: “what is” in economic matters
 Establishes a cause and effect relationship between
variables.
 Analyzes problems on the basis of facts.
 Normative economics: “what ought to be” in
economic matters.
 Concerned with questions involving value judgments.
 Incorporates value judgments about what the economy
should be like.
Types of Economic Analysis
contd..

 Short Run and Long Run

 Short run: Time period not enough for consumers and
producers to adjust completely to any new situation.
 Some inputs are fixed and others are variable

 Long run: Time period long enough for consumers and

producers to adjust to any new situation.
 All inputs are variable

 Decisions to adjust capacity, to introduce a larger

plant or continue with the existing one, to change

product lines.
Types of Economic Analysis
 Partial and General Equilibrium
 Partial equilibrium analysis: Related to micro analysis
 Studies the outcome of any policy action in a
single market only.
 Equilibrium of one firm or few firms and not
necessarily the industry or economy.
 General equilibrium: explains economic phenomena
in an economy as a whole.
 State in which all the industries in an economy are
in equilibrium.
 State of full employment
Managerial Economics

 Application of economic theory and the tools of analysis

of decision science to examine how an organisation can
achieve its objectives most effectively
 Study of allocation of the limited resources available to a
firm or other unit of management among the various
possible activities of that unit
 Applies economic theory and methods to business and
administrative decision-making
 Application of economic principles and methodologies to
the decision-making process within the firm or
organization
Managerial Economics
Contd…

 Micro as well as Macro

 Applied microeconomics: demand analysis, cost and
production analysis, pricing and output decisions
 Macroeconomic: national income, inflation and stages of
recession and expansion
 Normative Bias
 Prescriptive: States what firms should do in order to reach
certain objectives.
 Decides on whether or not the probable outcome of a
managerial decision is desirable.
 Decisions Resulting in Partial Equilibrium
 Decisions taken by any firm would relate to the equilibrium of
that particular firm.
 Deals with partial equilibrium analysis
Economic Principles Relevant to
Managerial Decisions
 Concept of scarcity
 Unlimited human wants
 Limited resources available to satisfy such wants
 Best possible use of resources to get:
 maximum satisfaction (from the point of view of consumers) or
 maximum output (from the point of view of producers or firms)
 Concept of opportunity cost
 Opportunity cost is the benefit forgone from the alternative
that is not selected.
 Highlights the capacity of one resource to satisfy multitude of
wants
 Helps in making rational choices in all aspects of business,
since resources are scarce and wants are unlimited
Economic Principles Relevant to
Managerial Decisions Contd…

 Concept of margin or increment

 Marginality: a unit increase in cost or revenue or
utility.
 Marginal cost: change in Total Cost due to a unit change in
output.
 Marginal revenue: change in Total Revenue due to a unit
change in sales.
 Marginal utility: change in Total Utility due to a unit change
in consumption.
 Incremental:applied when the changes are in bulk,
say 10% increase in sales.
Economic Principles Relevant to
Managerial Decisions
 Discounting Principle
 Time value of money : Value of money depreciates
with time
 A rupee in hand today is worth more than a rupee received
tomorrow.
 Outflow and inflow of money and resources at
different points of time
1
PVF = (1  r) n

where
PVF = Present Value of Fund,
n = period (year, etc.)
R = rate of discount
Production Possibilities Curve
 Highlights the concepts of scarcity and opportunity cost
 Indicates the opportunity cost of increasing one item's
production (or consumption) in terms of the units of the other
forgone
 Slope of the curve in absolute terms
 Assumptions
 The economy is operating at full employment.
 Factors of production are fixed in supply; they can however be
reallocated among different uses.
 Technology remains the same.
 Production Possibilities Curve
 Shows the different combinations
of the quantities of two goods
that can be produced (or
Technically
consumed) in an economy at any
Food Infeasible Area
point of time.
FP
P  Below the curve is productively
inefficient area and above it is
FQ Q technically infeasible area, so the
Productively equilibrium will be at the curve
Inefficient Area (FP and CP at point P).
 Depicts the trade off between any
two items produced (or
O consumed).
CP CQ Clothing
 To increase the quantity of
clothing from CP to CQ some
PPC for the Society amount of food (FP-FQ) will have
to be sacrificed. New point of
equilibrium on PPC is at Q.
Production Possibilities Curve
Contd…

 All points on the PPC (like P and Q) are points of

maximum productive efficiency.
 In the figure, OFp of food and OCp of clothing can be
produced at Point P and OFQ of food and OCQ
respectively at point Q, when production is run efficiently.
 All points inside the frontier are feasible but productively
inefficient.
 All points to the right of (or above) the curve are
technically impossible (or cannot be sustained for long).
 A move from P to Q indicates an increase in the units of
clothing produced and vice versa.
 It also implies a decrease in the units of food produced.
This decrease in the units of food is the opportunity cost
of producing more clothing.
Managerial Economics and
Functions of Management
 All functional areas have to find the most
efficient way of allocating scarce
organizational resources
 Managerial economics:
 Facilitates the process of evaluating
relationships between functional areas
 Helps in making rational decisions across
managerial functions.
Managerial Economics and
Functions of Management Contd…

 Financial Management
 From where to collect resources
 Equity
 Debt

 How to allocate resources

 How much profit to be retained/distributed
 Human Resource Management
 Recruitment
 Wage and Salary
 Training and development
 Retirement
Managerial Economics and
Functions of Management
 Marketing Management
 Which product
 For whom
 What price
 How to sell
 Operations Management
 Which technology
 Inputs
 Processing
 Information System Management
 Communication channels
 Use of information Technology
 Relationship Other Disciplines
Economic Theory
Microeconomics Quantitative Analysis
Theory of firm Numeric and algebraic analysis
Theory of consumer behaviour (demand) Optimization
Production and cost theory (supply) Discounting and time value of money
Market structure and competition techniques
Price theory Statistical estimation and forecasting
Macroeconomics
Game theory
National income and output
Business cycle
Inflation

Managerial Economics

Solutions to Managerial Decision Making

Quantity and quality of product
Price of product
Marketing Management
Financial Management
Human Resource Management
Research and Development
Summary
• Economics studies the choices made by individuals and societies in
regard to the alternative uses of scarce resources which are employed to
satisfy unlimited wants.
• Microeconomics is the study of the behaviour of individual economic units,
such as an individual consumer, a seller, a producer, a firm, or a product.
• Macroeconomics deals with the study of aggregates, the economy as a
whole.
• Ceteris paribus is a Latin phrase, literally translated as “with other things
(being) the same”.
• The assumption of rationality means that consumers and firms measure
and compare the costs and benefits of a decision before going ahead for
that decision.
• Partial equilibrium analysis studies the outcome of any policy action in a
single market only, while general equilibrium analysis seeks to explain
economic phenomena in an economy as a whole.
• Opportunity cost is the benefit forgone from the alternative that is not
selected.
Summary
• Concept of Time value of money tells that Value of money
depreciates with time.
• Concept of Marginal/increment tells about impact of
unit/proportionate change in cost/revenue on decision making.
• Managerial economics is a means to finding the most efficient way
of allocating scarce organizational resources and reaching stated
objectives. It is micro as well as macro in nature; it has a normative
bias, and deals with partial equilibrium.
• Production Possibilities Curve (PPC) is a graph that shows the
different combinations of the quantities of two goods that can be
produced (or consumed) in an economy, subject to the limited
availability of resources.
• The knowledge of managerial economics helps to understand the
interrelationships among the various functional units of any firm
(namely production, marketing, HR, finance, IT and legal)
• Decision sciences provide the tools and techniques of analysis used
in managerial economics, in particular numerical and algebraic
analysis, optimization, statistical estimation and forecasting.