Basic Economic Tools in Managerial Economics for been earned had the money been kept as fixed deposit in

Decision Making bank.

Economic theory offers a variety of concepts and analytical It’s clear now that opportunity cost requires ascertainment of
tools which can be of considerable assistance to the sacrifices. If a decision involves no sacrifices, its
managers in his decision making practice. These tools are opportunity cost is nil. For decision making opportunity
helpful for managers in solving their business related costs are the only relevant costs.
problems. These tools are taken as guide in making decision.
Incremental Principle: It is related to the marginal cost and
Following are the basic economic tools for decision making:
marginal revenues, for economic theory. Incremental
• Opportunity cost principle; concept involves estimating the impact of decision
alternatives on costs and revenue, emphasizing the changes
• Incremental principle; in total cost and total revenue resulting from changes in
• Principle of the time perspective; prices, products, procedures, investments or whatever may
be at stake in the decisions. The two basic components of
• Discounting principle; incremental reasoning are:

• Equimarginal principle. • Incremental cost

Opportunity Cost Principle: OC of a decision is the sacrifice • Incremental Revenue

of alternatives required by that decision; OC represents the
benefits or revenue forgone by pursuing one course of action The incremental principle may be stated as under: “A
rather than another; OC are not recorded in the accounting decision is obviously a profitable one if:
records of the firm, but have to be met if the firm aims at • It increases revenue more than costs,
optimization. OC is always higher to Accounting Costs.
Whenever a manager takes or makes a decision, he chooses • It decreases some costs to a greater extent than it
one course of action, sacrificing the other alternatives. We increases others,
can evaluate the one chosen in terms of the other (next best)
• It increases some revenues more than it decreases
which is sacrificed. All decisions which involve choice must
others and,
involve opportunity cost principle. OC may be either real or
monetary, either implicit or explicit, either non-quantifiable • It reduces cost more than revenues”
or quantifiable. Decisions involving opportunity cost
includes; Make or buy; Breakdown or preventive Principle of Time Perspective: Managerial economists are
maintenance of machines; Replacement or new investment also concerned with the short run and the long run effects of
decision; direct recruitment from outside or Departmental decisions on revenues as well as costs. The very important
promotion. Accountant never considers opportunity cost, he problem in decision making is to maintain the right balance
considers only explicit costs. between the long run and short run considerations. Decision
making is the task of co-coordinating along the time scale-
Accounting Profit = Revenue - Recorded Costs past, present and future. Whenever a manager confronts a
decision environment, he must analyze the present problem
Economic Profit = Revenue – (explicit + implicit costs)
with reference to the past data of facts, figures and
i.e. Economic Profit = Accounting profit-opportunity costs. observation in order to arrive at a decision, contemplating
For optimal allocation of scarce resources the manager clearly its future implications in terms of actions and
should consider the opportunity costs of using resources, reactions likely thereupon. Thus, time dimension is very
human or non-human, in a given activity; Decision principle important. Economist consider time in terms of concepts
should be minimization of opportunity costs, given like:
objectives and constraints. By the opportunity cost of a
i. Temporary run: the supply of output
decision is meant the sacrifice of alternatives required by
ii. Fixed short run: supply can be changed slightly by
that decision. For e.g.
altering the factor proportion (all factors are not
• The opportunity cost of the funds employed in one’s own variable)
business is the interest that could be earned on those funds if iii. Long run: All factors are variables, output level
they have been employed in other ventures. can be adjusted freely. There exist constraints in
temporary and short run, but none in long run for a
• The opportunity cost of using a machine to produce one manager
product is the earnings forgone which would have been iv. Short run is the (present) period and long run is
possible from other products. the future (remote) period
• The opportunity cost of holding Rs. 1000as cash in hand Manager must calculate the opportunity cost if they have to
for one year is the 10% rate of interest, which would have choose between the present and future. His decision
principle must take care of both time periods. He cannot • If an investment of a sum yields a series of return Ai
afford to have a time period which is too short Example: through i period; i=1n, then in order to calculate its present
• He may set a high price for his product today but then he value, we need to discount ∑ AI with the help of
should be prepared to face the declining sales
(1+r ) P =∑ Ai / (1+r )
I I

• Today the advertisement cost might inflate the prices but

tomorrow it may increase the revenue flow. • Longer the period, larger the discount factor, (1+r )I
exceeds. Heavy discounting for the distant period makes
• Management may ignore labor welfare today to reduce sense because future is uncertain; distant future involves
costs but in future this may deteriorate industrial relation incalculable risk.
climate with adverse effect on productivity and profitability
• Discounting enables risk hedging, particularly in context of
It is important for a manager to take a short and a long view investment decisions where the return on investment is
of his decision. For example, suppose there is a firm with a spread over a number of years in future
temporary idle capacity. An order for 5000 units comes to
management’s attention. The customer is willing to pay Rs • Present value of future return can be estimated by
4/- unit or Rs.20000/- for the whole lot but not more. The discounting it with the opportunity costs of the safe rate of
short run incremental cost (ignoring the fixed cost) is only interest.
Rs.3/-. Therefore the contribution to overhead and profit is
• Principle also has applications other than investments
Rs.1/- per unit (Rs.5000/- for the lot)
wages are equal to the discounted value of the marginal
Analysis: From the above example the following long run productivity of labor”
repercussion of the order is to be taken into account: If the
Thus one of the fundamental ideas in Economics is that a
management commits itself with too much of business at
rupee tomorrow is worth less than a rupee today.
lower price or with a small contribution it will not have
sufficient capacity to take up business with higher Marginal Principle: Due to scarce resources at the
contribution. If the other customers come to know about this disposable, the manager has to be careful of spending each
low price, they may demand a similar low price. Such and every additional unit of resources. In order to decide
customers may complain of being treated unfairly and feel whether to use an additional man hour or machine hour or
discriminated against. In the above example it is therefore not you need to know the additional output expected from
important to give due consideration to the time perspectives. there. A decision about additional investment has to be
“A decision should take into account both the short run and viewed in terms of additional returns from the investment.
long run effects on revenues and costs and maintain the right Economists use the word “Marginal” for additional
balance between long run and short run perspective”. magnitudes of production or return. Economist often use the
terms like:
Discounting Principle: Discounting is both a concept as well
as technique borrowed from accountancy. For explanation • Marginal output of labor
readopt the opportunity and time perspective.
• Marginal output of machine
Consider the case of the seller. The seller has to decide
between the immediate cash payment of Rs. 1000 by his • Marginal return on investment
customer and the future payment of say Rs. 1100 at the end • Marginal revenue of output sold
of one year from now.
• Marginal cost of production
• Human nature is such that there is time preference for
present • Marginal utility of consumption

• For the seller it is better to get Rs 1000 now and keep it in Economic Behavior: An Overview
bank at 10 % rate of interest and realize Rs 1100 thereby.
Individuals have unlimited wants. People generally want
• Should we say that the present value of future sum of greater wealth, more attentive service, larger houses, more
Rs.1100 is just Rs. 1000? luxurious cars, and additional personal material items. They
want more time for leisure activities. Most also want to
• How have we arrived at this?
improve the plight of others—starving children, the
• A1= P+ rP or P = A1 /(1+r) homeless, and disaster victims. People are concerned about
vitality, religion, integrity, and gaining the respect and
• Second Year, P = A2 /(1+r )2 affection of others.

In contrast to wants, resources are limited. Households face

limited incomes that preclude all the purchases and
expenditures that household members might like to make.
The available amount of land, trees, and other natural marginal benefit for making each additional sales call is $50.
resources is finite. There are only 24 hours in a day. People Mary enjoys playing tennis more than selling. If she places a
become ill; death is inevitable. marginal value of more than $50 on the tennis that she
would forgo by making an extra call, she should not make
Economic Choice any more sales calls that day—the marginal costs would
Economic analysis is based on the notion that individuals have exceeded the marginal benefits. She continues to make
assign priorities to their wants and choose their most additional sales calls as long as the reduction in tennis
preferred options from the available alternatives. If Kathy playing is valued at less than $50.
Measer is confronted with a choice between a laptop or a Marginal analysis is a cornerstone of modern economic
desktop computer, she can tell you whether she prefers one analysis. In economic decision making, “bygones are
over the other or whether she is indifferent between the two. forever bygones.” Costs and benefits that have already been
Depending on the relative prices of the two products, she incurred are sunk (assuming they are non-recoverable) and
purchases her preferred alternative. If Kathy has a weekly hence are irrelevant to the current economic decision. Mary
budget of $1,000, she considers the many ways she might paid $5,000 to join a tennis club last month. This fee does
spend the money and then chooses the package of goods and not affect her current decision of whether to play tennis or
services that will maximize her personal happiness. She make an extra sales call. That expenditure is ancient history
cannot make all desired purchases on her limited budget. and does not affect Mary’s current trade-offs.
However, this choice is optimal for Kathy, given her limited
resources. As another example, consider Ludger Hellweg who owns a
company that installs wood floors. He is offered $20,000 to
Economists do not assert that people are selfish in the sense install a new floor. The cost of his labor and other operating
that they care only about their own personal consumption. expenses (excluding the wood) are $15,000. He has wood
Within the economic paradigm, people also care about such for the job in inventory. It originally cost him $2,000. Price
things as charity, family, religion, and society. For instance, increases have raised the market value of the wood to
Kathy will donate $100 to her church, as long as the $6,000, and this value is not expected to change in the near
donation provides greater satisfaction than alternative uses future. Should he accept the contract?
of the money.
He should compare the incremental costs and benefits from
Economists, however, often assume for modeling purposes the project. The marginal benefit is $20,000. The marginal
that people care only about their own wealth to simplify the cost is $21,000—$15,000 for the labor and operating
analysis. While wealth is not the only thing that people care expenses and $6,000 for the wood. The historic cost for the
about, it is very important to most people. Economic models wood of $2,000 is not relevant to the decision. To replace
based on this simplifying assumption often perform quite the wood used on this job costs $6,000. Since the marginal
well relative to more complicated models that add costs exceed the marginal benefits, Ludger would be better
unnecessary complexity to the analysis. Some situations, off rejecting the contract than accepting it. This example
however, can require models that are based on different illustrates that in calculating marginal costs, it is important
assumptions. to use the opportunity cost of the incremental resources, not
Economists do not contend that individuals are their historic (accounting) cost.
supercomputers that make infallible decisions. Individuals Opportunity Cost
are not endowed with perfect knowledge and foresight, nor
is additional information costless to acquire and process. For Because resources are constrained, individuals face trade-
example, Kathy might order an item from a restaurant menu offs. Using limited resources for one purpose precludes their
only to find that she dislikes what she is served. use for something else. For example, if Larry Matteson takes
four hours to play golf, he cannot use that same four hours
Within this economic paradigm, she simply does the best
to paint his house. The opportunity cost of using a resource
she can in the face of her imperfect knowledge. But she
for a given purpose is its value in its best alternative use.
learns from her experience and does not repeat the same
The opportunity cost of using four hours to play golf is the
mistakes in judgment time after time.
value of using the four hours in Larry’s next best alternative
Marginal Analysis use. Marginal analysis frequently involves a careful
consideration of the relevant opportunity costs.
Marginal costs and benefits are the incremental costs and
benefits that are associated with making a decision.4 It is Marginal Analysis
the marginal costs and benefits that are important in
Fortunately, we can use a basic decision-making method,
economic decision making. An action should be taken
called marginal analysis, to identify the optimal site with
whenever the incremental benefits of that action exceed its
much less computational effort. Marginal analysis is the
incremental costs. Mary O’Dwyer has a contract to help sell
process of considering small changes in a decision and
products for an office supply company. She is paid $50 for
determining whether a given change will improve the
every sales call that she makes to customers. Thus, Mary’s
ultimate objective. Because this definition is a mouthful, Marginal cost (MC) is the additional cost of producing an
let’s see how the method works in siting the mall. extra unit of output.

Let’s begin with an arbitrary location, say, point X. It is not The algebraic definition is:
necessary to compute its TTM. Instead, we consider a small
Marginal Cost = [Change in Cost] / [Change in Output]
move to a nearby site, such as town C. (The direction of the
move, east or west, is unimportant.) Then we ask, what is = ΔC/ΔQ = [C 1-C 0] / [Q 1-Q 0]
the change in the TTM of such a move? The clear result is
that the TTM must have declined. The eastward move The computation of MC is particularly easy for the
means a 1-mile reduction in travel distance for all customers microchip manufacturer’s cost function in Equation 2.4.
at C or farther east (70,000 trip-miles in all). From the cost equation, C = 100+38Q, it is apparent that
producing an extra lot (increasing Q by a unit) will increase
Therefore, the TTM is reduced by this amount. Of course,
cost by $38 thousand. Thus, marginal cost is simply $38
travel distances have increased for travelers at or to the west
thousand per lot. Note that regardless of how large or small
of X. For these customers, the TTM increase is 25,000 trip-
the level of output, marginal cost is always constant. The
miles. Therefore, the net overall change in TTM is 70,000
cost function in Equation 2.4 has a constant slope and thus
25,000 45,000 trip-miles. Total TTM has declined because
also an unchanging marginal cost. (We can directly confirm
the site moved toward a greater number of travelers than it
the MC result by taking the derivative of the cost equation.)
moved away from. Town C, therefore, is a better location
than site X.

Next, because the original move was beneficial, we try

moving farther east, say, to town D. Again, the move
reduces the TTM. (Check this.) What about a move east
again to town E? This brings a further reduction. What about
a move to town F? Now we find that the TTM has increased.
(By how much?) Moreover, any further moves east would
continue to increase the TTM. Thus, town E is the best site.

It is worth noting the simple but subtle way in which we

found the optimal site. The simple maxim of marginal
analysis is as follows:

Make a “small” move to a nearby alternative if and only

if the move will improve one’s objective (in this case,
reduce TTM). Keep moving, always in the direction of
an improved objective, and stop when no further move
will help.

The subtlety of the method lies in its focus on changes. One

need never actually calculate a TTM (or even know the
distances between towns) to prove that town E is the optimal
location. (We can check that town E’s TTM is 635.) One
requires only some simple reasoning about the effects of
changes.

Of course, on the tip of your tongue may be the declaration,

“This problem is too simple; that is the only reason why the
method works.” This protest is both right and wrong. It is
true that this particular location problem is special and
therefore somewhat artificial. (Two-dimensional siting
problems are both more realistic and more difficult.) But the
simplicity of the setting was not the key to why marginal
analysis worked. The method and its basic reasoning can be
used in almost any optimization problem, that is, in any
setting where a decision maker seeks to maximize (or
minimize) a well-defined objective.

Marginal Cost