Managerial Economics

Module-1

Managerial Economics is the process of decision making with the help of economic theory or
tools .It is that branch of economics which serves as a link between abstract theory and
Managerial practice. It is based on economic analysis for identifying problems ,organizing
information and evaluating alternatives.

Managerial Economics means the application of economic theory to the problem of

Management. It applies economic theory mainly micro economics to Business and
administration decision making, because it uses the tools and techniques of economic analysis to
solve managerial problems.

Definition:

In the words of spencer and siegelman “ Managerial economics is the integration of

economic theory with business practice for the purpose of facilitating decision making and
forward planning by management.”

Brigam and Pappas believe that Managerial economics is “ the application of economic
theory and methodology to business administrative practice.”

Nature:

1 .Managerial economics is micro economic in character as it concentrates only on the study of

the firm.

2. Managerial economics takes the help of macro economics.

3. Managerial economics is normative rather than the positive in character.

4. The contents of managerial economics are based mainly on theory of firm.

5. Knowledge of managerial economics helps in making wise choices.

Scope :

1. Demand Analysis and Fore Casting: The analysis and demand Forecasting of demand
for a given product and service is the first task of managerial economist.
2. Cost and Production Analysis: The costs of inputs in relation to output are studied to
optimize the profits. Production function and cost function are estimated given certain
parameters.
3. Price output Decision: When the production is ready and next task in to determine price
in different market situation such as perfect, Monopoly, Monopolistic etc;
4. Profit related Decision: We employ the techniques such as break even analysis, cost
reduction, cost control and ratio analysis to ascertain the level of profits.
5. Investment Decision: Investment decision are also called capital budgeting decision. It
is necessary to study the cost of capital, choice of capital structure and investment
projects before the funds are committed.
6. Analysis of Business Environment: The firm operation in an environment which is
dominated by the external and internal factors. The external factors include government
policies, competition, employment, labour, price income levels. The internal factors
include its policies, procedures relating time, market and products.

Business Decision Making Process:

Decision Making is the actual selection from among alternatives of a course of action. It
is the process of deciding about something important especially in a group of people or in an
organization.

Steps in Decision Making Process:

1. Defining the problem : Analysing problem and how it emerged listens to all the
symptoms
2. Information Gathering : From various sources develop alternatives.
3. Developing Alternative Solution : Identify clearly.
4. Evaluate the Alternatives : Find out pros and cons of each.
5. Selecting the right alternative: Based on the careful analysis
 6. Implementing the alternative chosen.
7. Analyzing the Results.

Relationship of ME with other Disciplines :

Managerial Economics is closely linked with many other disciplines such as economics, ,
mathematics, statistics, operation research, accountancy.

Economics: ME is the branch of economics and hence the concepts of ME are basically
economic concepts. If economics deals with the financial concepts, ME is the application of
these in real life.

Mathematics: Managerial Economist concept concerned with estimating the relevant economic
factors for decision making. In this process, he makes use of tools and techniques of mathematics
such as algebra, calculus, exponential, input-output tables, and such other.

Statistics: Statistics deals with different techniques which are useful to analyze the course and
effect relationships in a given variable. It also empowers the management to deal with the
solution of risk and uncertainty through the techniques such as probabilities, averages,
correlation, regression and so on.

Operation Research: Decision making in the main focus in operation research and Managerial
Economics. If Managerial Economics focuses on problem of decision making, operative research
focuses on solving managerial problems. So in the tools for finding the solution for many
management problems. Or models such as linear programming, queuing transportation,
optimization techniques and so on.

Accountancy: The accountant provides accounting information relating to costs, and revenues.
The main objective of accounting function in to record, classifying and interpreting he given
analysis data. The Managerial Economist depends upon accounting data for decision making.

Role of Managerial Economist:

Making decisions and processing information are the two primary tasks of managers. In
order to make intelligent decisions , managers must be able to to obtain , process and use
information . The purpose of learning economic theory is to help managers know what
information should be obtained and hpw to process and use the information.

The task of organizing and processing information and then making on intelligent
decision based upon this information and the basic theory can take two general forms. They are

A.Specific Decisions

B. General Tasks

A.Specific Decisions : Managerial economist undertakes the following specific functions. They
are

1.Production Scheduling

2. Demand forecasting

3.Market Research

4.Economic analysis of the industry

5.Investment Appraisal

6.Security management analysis

7.Advice on foreign Exchange management

8.Advice on Trade

9.Pricing and Related Decisions

10.Analysing and Forecasting Environmental factors.

B. General Tasks : Economic theory helps decision makers to know what information is
necessary to make an intelligent decision to find the correct solution to a problem and to learn
how to process and use that information. After obtaining the desired information or as such
information as is economically feasible to obtain, the manager must analyse this information and
use it in correspondence with the theoretical and statistical tools available to make the best
decision possible under circumstances.
 Business is influenced by two sets of decision factors. They are 1.Internal factors

2 External factors

1.Internal Factors: The role of managerial economist in internal managementis an important as

his contribution towards the management of external factors. He helps in deciding about
production, sales and inventory schedules of the firm.

2.External factors: The most important external factors in general economic conditions of the
economy, such as the level and rate of growth of national income, regional income distribution,
influence of international factors on the domestic economy ,the business cycle etc.,

The second important external factor for the firm is the prospects of demand for the
product.

Thirdly, the managerial economist also tries to find out if there is anything which is
influencing the input cost of the firm.

Fouthly, the market condition of raw material and finished product is also a subject of
study by the managerial economist.

Lastly, Managerial economist has to keep in touch with government economic policies
and the central bank monetory policies, annual budgets of Government etc.,
Q: What is meant by firm and explain the objectives of firm.

A: The firm is a unit engaged in production of goods and services. The firm include all
those enterprises which are related to not only production of goods but also of services. The firm
may be on individual proprietor or joint stock company.

Objectives of firm:

1. Profit Maximization
2. Sales Maximization
3. Growth Maximization
4. Long run Profit Maximization
5. Social Environmental Concerns

Profit Maximization Theory:

In the neo-classical theory of the firm, the main objective of a business firm is profit
maximization. The firm maximization its profits when it satisfies the following two rules.

1. Marginal cost (MC) = Marginal Revenue (MR)

2. MC Curve cuts the MR curve from below

Maximum profits refer to pure profits which are a surplus above the average cost of
production.

It is the amount left with the entrepreneur after he has made payments to all factors of
production, including his wages of Management.

The Profit Maximization condition of the firm can be expressed as

Maximize P(Q) = Max R(Q)-Max C(Q)

Where, P(Q) = Profit

R(Q) = Revenue
 C(Q) = Cost

Assumptions:

1. The objectives of the firm is maximize its profits where profits are the difference between
the firm’s revenue and cost
2. The firm has complete knowledge about the amount of output which can be sold at each
price.
3. The firm is a single ownership one and it is run by its owner called entrepreneur.
In the above graph, Revenue and Cost are shown on Y axis. Quantity of goods is shown on X
axis. Profit is the distance between Total Revenue (TR) and Total Cost (TC), the Profit
Maximizing output will occur when gap between TR and TC in maximum. In the above
graph TR and TC curves represent the total cost and total revenue for different output levels.
The gap between TR and TC curves in maximum of output OQ 2 where the slopes of the two
curves are equal. Since slopes of total cost and total revenue curves are marginal cost (MC)
and Marginal Revenue (MR) respectively, it implies that profit is maximized at the output
level where MR=MC.

Concept of Opportunity Cost:

Opportunity cost represents the benefits or revenues forgone by pursuing one course of
action rather than another. When a choice is made in favour of a particular alternative that
appears to be most desirable of all the given alternatives, if obviously implies that the next
best alternative which has been chosen. The benefits of the next best alternative which has
been sacrificed due to the choice of the best alternative is known as Opportunity cost of best
alternative.

The opportunity Cost Concept:

The concepts of opportunity cost is abundantly used by both branches of economics i.e.
micro and macroeconomics. It refers to the benefit of revenue foregone by availing one
course of action rather than another.
The opportunity cost here means the sacrificed alternative. That alternative quantify the
worth
of best alternative choice forego by selecting from a set of alternative options.
For example, if a person employed funds in his own business, the opportunity cost of those
invested funds is the interest if they had been employed somewhere else. As we know that
the resources are scare and firm cannot produce all the commodities itself. The produce has
to sacrifice the production of one commodity for producing another commodity and forced
to make a choice.

It proves the significance of the concept of opportunity cost in business decisions where the
firm has to make a choice between various courses of action.
The opportunity cost concept infers the following points:
a. Sacrifice is measured while calculating opportunity cost
b. The cost of sacrificed option in known as opportunity cost
c. The opportunity cost will be zero when the resource has no alternate use
d. Opportunity cost doesn’t appear in the books of account as is just a imaginary idea
e. Opportunity cost (sacrifice) can be real or in the form of money

The opportunity cost concept has a significant place in business decision making. The
concept has economic significance as it helps in:
a. Deciding relative prices of commodities
b. Determining factor (inputs) remuneration
c. Optimal allocation of available resources

Time Perspective

Economists often make a difference between short run and long run. Short run means the
periods which is within one year and in within period some of the inputs cannot be changed
like fixed inputs. While in the long run all the inputs can be changed both variable inputs and
fixed inputs. Thus in the short run changing output can be achieved by changing some of the
inputs while the same can be achieved in the long run by adjusting scale of output and size of
the firm.
The Time Perspective Concept
The concept of time concept draws a clear distinction between short run and long run time
period. This distinction is not based on any calendar period, like a month or a year rather
based on the quickness of the decisions can be made and variability of the factors. The time
element in economic theory was introduced by Marshall. The short run is the time period in
which a firm can only alter its factors of production like labour and raw materials. The firm
has to change its output without changing its size.The firm can easily increase its output in the
long run because the firm has enough time to alter its size as well as can use both fixed and
variable factors in the production process. In managerial economics, the consequences of the
decisions during short run and long run are taken into consideration and maintain a right
balance among these time perspectives.The average cost of a firm may be more or less as
compared to its average revenue in short run time period, but in the long run the average
revenue and average cost will be same. The economists are much concerned about short run
and long run time period effects on a firm’s profitability and establish a balance between the
two time periods.

Discounting Principle:

The concept of discounting principle is based on the fundamental fact that a rupee now
is more worth than a rupee earned after one year. For example, you are given a choice of Rs
1000 today or Rs 1000 in the next year. Naturally, you will choose Rs 1000 today.

Some investments may yield higher returns for only a limited number of years, while the
others a small return for a longer period. Thus, even the same amount of investment in two
alternative uses may have different annual returns and a different duration of such returns. To
transform these returns in to common measure we use discounting principle. Suppose an
investor wants to invest Rs 100,assuming rate of interest is 10%, his income will be grown
from Rs 100 to Rs 110 in the next year. In other words Rs 110 in the next year is equal to Rs
100 at present.
Risk and Uncertainity:

Risk is a situation in which probability distribution of a variable is known but its actual
value is not known.It means there are chances of loss but how much loss is uncertain .So,
Risk may be defined as uncertainity of financial loss on the occurance of an unfortunate
event.

Uncertainity is a situation regarding a variable in which neither its probability

distribution nor its mode of occurance is known. So, Uncertainity is a situation regarding
which which nothing predictable and no one knows what going to be happened. Uncertainity
arises when actual condition differ from anticipated condition.

The basic difference between Risk and uncertainity is that un certainity no one knows
what will be outcome, but under risk every one know the outcome will be loss, but do not
know how much loss.