FUNDAMENTAL CONCEPTS IN

MANAGERIAL ECONOMICS
 FUNDAMENTAL CONCEPTS/PRINCIPLES IN
MANAGERIAL ECONOMICS
• Economic principles/concepts assist in rational reasoning and defined thinking. They
develop logical ability and strength of a manager.
 FUNDAMENTAL CONCEPTS/PRINCIPLES IN MANAGERIAL ECONOMICS

• Economic theory provides a number of con­cepts and analytical tools which can be of
considerable and immense help to a manager in taking many decisions and business
planning.

• The contribution of economics to managerial economics lies in certain principles which

are basic to managerial economics. There are few basic principles of managerial
economics. They are:

1. The Opportunity Cost Principle

2. The Principle of Time Perspective

3. The Discounting Principle

4. The Incremental Principle

5. The Equi­marginal Principle

BASIC CONCEPTS IN ECONOMICS

 SCARCITY
 CHOICE
 RESOURCE ALLOCATION
 TRADE OFF
 OPPORTUNITY COST
 SCARCITY

• Scarcity refers to the basic economic problem

• Resources are limited and scarce
• Needs and wants are unlimited
• This situation requires people to make decisions about how to
allocate resources efficiently, in order to satisfy basic needs and as
many additional wants as possible.
 CHOICE

• Resources are scarce and the available resources have

alternative uses
• Thus the consumer forced to choose the best from available
alternative.
 RESOURCE
ALLOCATION

•Analysis of how scarce resources are

distributed among producers

•How scarce goods and services are apportioned

among consumers

•This analysis takes into consideration the

accounting cost, economic cost, opportunity
cost, and other costs of resources and goods and
services
 TRADE –OFF

Due to scarcity of resources , human beings

are forced to make a choice. Choice
involves a trade-off between costs and
benefits. This will lead to giving up
something to get something else.

Trade-off means giving up one goods or

activity to obtain some good or another
activity or accepting less of one thing for
more of another.
 Thus scarcity leads to choice,

 Choice leads to trade off,

 Which in turn leads to opportunity cost.

 OPPORTUNITY COST
 It is the cost of next best alternative which has been given up.
 It is the value of alternative foregone in order to have something else
 The cost of next best alternative forgone
 OPPORTUNITY COST
PRINCIPLE

Opportunity cost is one of the most important and fundamental concepts in the
whole of economics. Given that we have said that economics could be
described as a science of choice, we have to look at what sacrifices we make
when we have to make a choice. That is what opportunity cost is all about.
 OPPORTUNITY COST
Resources are scarce, we cannot produce all the commodities. For the production of one com­
modity, we have to forego the production of another commodity. We cannot have everything we
want. We are, therefore, forced to make a choice.

Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of
alternatives is involved when carrying out a decision requires using a resource that is limited in
supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by
pursuing one course of action rather than another.

The concept of opportunity cost implies three things:

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

2. Sacrifices may be monetary or real.

3. The opportunity cost is termed as the cost of sacrificed alternatives.

 SACRIFICE OF ALTERNATIVES

• Opportunity cost is the minimum price that would be necessary to retain a

factor-service in it’s given use. It is also defined as the cost of sacrificed
alternatives.

• By opportunity cost of a decision is meant the sacrifice of alternatives required

by that decision.
• It is the earning that would be realized if the available resources were put to
some other use. Thus opportunity cost is measures in terms of the sacrifice
made behind the decision.

• Consider that a person has invested a sum of Rs. 50,000 in shares. Let the
expected annual return by this alternative be Rs. 7,500. If the same amount
is invested in a fixed deposit, a bank will pay a return of 18%. Then, the
corresponding total return per year for the investment in the bank is Rs.
9,000. This return is greater than the return from shares. The foregone
excess return of Rs. 1,500 by way of not investing in the bank is the
opportunity cost of investing in shares.
 IMPORTANCE OF OPPORTUNITY COST
In managerial decision making, the concept of opportunity cost occupies an important place. The economic
significance of opportunity cost is as follows:

1. It helps in determining relative prices of different goods:

For Example : If a given amount of factors can produce 1 table or 3 chairs, then the price of one table will tend to be
equal to three times that on one chair.

2. It helps in determining normal remuneration to a factor of production:

For Example: Let us assume that the alternative employment of a college professor is to work as an office in a bank at
a salary of Rs. 40000 per month. In such a case he has to be paid at least Rs.40000 to continue to retain him in the
college.

3. It helps in proper allocation of factor resources:

For Example: Opportunity cost of 1 table is 3 chairs and price of a chair is Rs.100, while the price of a table is
Rs.400. Under such conditions it is beneficial to produce 1 table rather than 3 chairs. Because, if he produce 3
chairs, he will get only Rs.300, whereas a table fetches him Rs. 400.
 TIME PERSPECTIVE PRINCIPLE
According to this principle, a manger 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. Economists often make a distinction between
short run and long run. It was Marshall who introduced time element in economic
theory.
• Short run means that period within which some of the inputs (called fixed
inputs) cannot be altered.

• Long run means that all the inputs can be changed.

• Economists try to study the effect of policy decisions on variables like prices,
costs, revenue, etc, in the light of these time distinctions.
 PRINCIPLE OF TIME PERSPECTIVE

• The time perspective concept states that the decision maker must give due
consideration both to the short run and long run effects of his decisions. He /
She must give due emphasis to the various time periods.

• By Short run they mean that period within which some of the inputs (called fixed
inputs) cannot be altered, while in the long run all the inputs can be changed. In the
short period, the firm can change its output without changing its size.

• In the long period, the firm can change its output by changing its size.
• In the short period, the output of the industry is fixed because the firms cannot
change their size of operation and they can vary only variable factors. In the long
period, the output of the industry is likely to be more because the firms have
enough time to increase their sizes and also use both variable and fixed factors.

• A decision may be made on the basis of short run considerations, but may as time
elapses have long run repercussions which make it more or less profitable than it
at first appeared.

• For example- a business firm can earn more profit in the short run by charging a
higher price during this period of scarcity but it will lose its customer ‘s goodwill
and impair its long run survival.
• Exp- Suppose a firm is not utilizing its production capacity in full. It is manufacturing a
particular product and selling is at Rs. 200 per unit. The cost of producing the product is Rs.
160 per unit ( Rs. 120 per unit on variable cost and Rs. 40 on fixed costs). Firm gets an order
of supplying of 2000 units at the rate of Rs. 160 per unit.

• If this order is evaluated with short run perspective, it seems to be profitable because it will
fetch a net revenue of Rs. 320000, if it is evaluated with long run perspective, the following
question arise :

a) If such order are accepted repeatedly at the same price, profitability of the firm will decrease
substantially

b) If the regular customers of the firm come to know about the practice of firm of accepting
orders below full cost, they may demand reduction in regular selling price of the production

c) The decision of accepting an offer at a price that does not cover the cost of production in full,
may adversely affect the image of the firm.
 INCREMENTAL/MARGINAL PRINCIPLE
 Incremental concept is closely related to the mar­ginal cost and marginal revenues
of economic theory.

 While taking a decision, a manager always determines the decision on the basis of
criterion that the incremental revenue should exceed incremental cost.

 The marginal/Incremental analysis states that optimal managerial decisions involve

comparing the marginal (or incremental) benefits of a decision with the marginal
(or incremental) costs.
 INCREMENTAL
PRINCIPLE

• This principle states that a decision is said to be rational and

sound if given the firm’s objective of profit maximization, it leads
to increase in profit, which is in either of two scenarios-

– If total revenue increases more than total cost

– If total revenue declines less than total cost
• The two basic concepts in the incremental analysis are :
incremental cost and incremental revenue.

Incremental cost may be

Incremental Revenue
defined as the change in total
is change total
in revenue
cost as a result of change
resulting from change in
the
in level of output,
level of output , price etc.
investment, etc

• Use of Incremental Reasoning- While taking a decision, a manager

always determines the worthiness of a decision on the basis of criterion
that the incremental revenue should exceed incremental cost.
 EXAMPLE OF INCREMENTAL PRINCIPLE

Some businessmen hold the view that to make an overall profit, they must make a profit on
every job. The result is that they refuse orders that do not cover full costs plus a provision
of profit. This will lead to rejection of an order which prevents short run profit.

Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000. The
costs are estimated as under:
Labour Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and Rs. 1,400
administrative Rs.12, 000
expenses
The order appears to be unprofitable. For it results in a loss of Rs. 2,000.
Full Cost
 EXAMPLE OF INCREMENTAL PRINCIPLE
•However, suppose there is idle capacity which can be utilised to execute this
order.
•If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of
labour cost because some of the idle workers already on the pay roll will be
deployed without added pay and no extra selling and administrative costs, then
the actual incremental cost is as follows:

Labour Rs. 2,000

Materials’ Rs. 4,000
Overhead charges Rs. 1,000
Total Rs. 7,000
Incremental
Cost
Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of
incremental reasoning.
 EQUI-MARGINALISM PRINCIPLE
• The law of Equi-marginal Utility has been given by Marshall. This law is one of the
basic principles of Economics. The Law of Equi-marginal utility is known with several
names, such as; Law of Substitution, Law of Maximum Satisfaction ,Law of
Indifference, Law of Proportionality, Law of economy, etc.

• Law of Equi-Marginal Utility explains the relation between the consumption of two or
more products and what combination of consumption these products will give
optimum satisfaction. Marginal Utility is the additional satisfaction gained by
consuming one more unit of a commodity.

• In order to maximise satisfaction with a limited amount of money a consumer has to

compare the satisfaction obtained from each rupee that he spends on different
commo­dities.
• Major assumptions of this principle:
A. The consumer acts rationally.
B. Tastes and preferences, money income, prices of goods, etc., remain constant.

The equi-marginal principle is based on the law of diminishing marginal utility. The
equi-marginal principle states that a consumer will be maximizing his total utility
when he allocates his fixed money income in such a way that the utility derived from
the last unit of money spent on each good is equal.

In the real world, a consumer may purchase more then one commodity. Let us
assume that a consumer purchases two goods X and Y. How does a consumer
spend his fixed money income in purchasing two goods so as to maximize his total
utility? The law of equi­-marginal utility tells us the way how a consumer maximizes
his total utility.
• In other words, he substitutes some units of a commodity giving more utility for some units giving
less utility. As a result of this substitution that the marginal utility of the former will fall and that of the
latter will rise. This will continue until the two marginal utilities are equalised. This is equal to the Law
of Subs­titution or the Law of Equi-marginal Utility.

• Table 4.3: Marginal Utility of Two Commodities

• Suppose chocolates and ice-creams are two purchasable goods. Suppose further that the consumer
has Rs. 70 to spend. Let us spend Rs. 30 on ice-creams and Rs. 40 on chocolates. What is the
result? The utility of the 3rd unit of ice-creams is 6 and that of the 4th unit of chocolates is 2. As the
marginal utility of ice-cream is higher the consumer would buy more of ice-creams and less of
chocolates.
• The total utility of 4 ice-creams would be 10 + 8 + 6 + 4 = 28 and of three
chocolates 8 + 6 + 4=18 which gives us a total utility of 46. The satisfaction
given by 4 ice-creams and 3 chocolates at Rs. 10 each is greater than could be
obtained by any other combination of the two goods. For no other combination
does this utility amount to 46.

• So the conclusion is that we obtain maxi­mum satisfaction when we equalise

marginal utilities by substituting the more useful for the less useful commodity.
Example:2
• In Table we have shown marginal utility schedule of X and Y from the different units
consumed. Let us also assume that prices of X and Y are Rs. 4 and Rs. 5,
respectively.
• MUX and MUY schedules show dimini­shing marginal utilities for both goods X and Y
from the different units consumed. Dividing MUX and MUY by their respective prices
we obtain weighted marginal utility or marginal utility of money expenditure. This
has been shown in following table:
• MUX/PX and MUY/PY are equal to 6 when 5 units of X and 3 units of Y are
purchased. By purchasing these combinations of X and Y, the consumer spends
his entire money income of Rs. 35 (= Rs. 4 x 5 + Rs. 5 x 3) and, thus, gets
maximum satisfaction [10 + 9 + 8 + 7 + 6] + [11 + 10 + 6] = 67 units. Purchase of
any other combination other than this involves lower volume of satisfaction.
• So, clearly it can be observed from the examples that a utility maximizing consumer
distributes his consumption expenditure between various goods and services
he/she consumes in such a way that the marginal utility derived from each unit of
expenditure on various goods and service is the same.

• The laws of equi-marginal utility states that a consumer will reach the stage of
equilibrium when the marginal utilities of various commodities he consumes are
equal.
 DISCOUNTING PRINCIPLE/TIME VALUE OF
MONEY

• The concept of discounting future is based on the fundamental fact that a

rupee now is worth more than a rupee earned a year after.

• Unless these returns are discounted to find their present worth, it is not
possible to judge whether or not it is worth undertaking the investment today.
Thank You