Introduction to T

Managerial Economics
UNIT 2 THE FIRM: STAKEHOLDERS, O
OBJECTIVES AND DECISION
ISSUES
Objectives

After studying this unit, you should be able to:

 understand the rationale for existence of firms;
 understand the concept of economic profit and accounting profit;
 appreciate the use of opportunity cost;
 differentiate between various objectives of the firm.

Structure

2.1 Introduction
2.2 Objective of the Firm
2.3 Value Maximization
2.4 Alternative Objectives of the Firms
2.5 Goals of Real World Firms
2.6 Firm’s Constraints
2.7 Basic Factors of Decision-Making: The Incremental Concept
2.8 The Equi-Marginal Principle
2.9 The Discounting Principle
2.10 The Opportunity Cost Principle
2.11 The Invisible Hand
2.12 Summary
2.13 Self-Assessment Questions
2.14 Further Readings

2.1 INTRODUCTION
The firm is an organisation that produces a good or service for sale and it
plays a central role in theory and practice of Managerial Economics. In
contrast to non-profit institutions like the ‘Ford Foundation’, most firms
attempt to make a profit. There are thousands of firms in India producing
large amount of goods and services; the rest are produced by the government
and non-profit institutions. It is obvious that a lot of activities of the Indian
economy revolve around firms.

One of the crucial determinants of a firm’s behaviour is the state of

technology. Technology imposes a limit on how much a firm can produce. It
is the sum total of society’s pool of knowledge concerning the industrial and
agricultural arts. Production is any activity that transforms inputs into output
and is applicable not only to the production of goods like steel and
automobiles, but also to production of services like banking and insurance.

The firm changes hired inputs into saleable output. An input is defined as
anything that the firm uses in its production process. Most firms require a
wide array of inputs. For example, some of the inputs used by major steel
firms like XYZ or ABC are iron ore, coal, oxygen, skilled labour of various
22
types, the services of blast furnaces, electric furnaces, and rolling mills as The Firm: Stakeholders,
well as the services of the people managing the companies. To give another Objectives and Decision
example, the inputs in production and sale of “chaat” by a street vendor are Issues
all the ingredients that go into making of the “chaat”, i.e. the stove, the
“carrier”, and the services of the vendor. The inputs or the factors of
production are divisible into two broad categories – human resources and
capital resources. Labour resource and entrepreneurial resource are the two
human resource inputs while land, man-made capital forests, rivers, etc. are
the two capital resources. Thus the four major factors of production (FOP)
are land, man-made capital, labour, and entrepreneur (organisation) while the
remuneration they get is rent, interest (capital rental), wage, and profit,
respectively.

The function of the firm, thus, is to purchase resources or inputs of labour

services, capital and raw materials in order to convert them into goods and
services for sale. There is a circular flow of economic activity between
individuals and firms as they are highly interdependent. Labour has no value
in the market unless there is a firm willing to pay for it. In the same way,
firms cannot rationalize production unless some consumer is willing to buy
their products. However, there is some incentive for each. Firms earn profits
in turn satisfying the consumption demand of individuals and resource
owners get wage, rent and interest payment. In the process of supplying the
goods and services that consumers demand, firms provide employment to
workers and also pay taxes that government uses to provide service
(education, defence) that firms could not provide at all or as efficiently.

Essentially a firm exists because the total cost of production of output is

lower than if the firm did not exist. There are several reasons for lower costs.
Firstly, long term contract with labour saves the transaction costs because no
new contract has to be negotiated every time a labour is to be hired or given
new assignment. Secondly, there are government regulations like price-
control and sales taxes also saved by having the transaction within the firm.
Recall that sales tax is levied for transaction between firms and not within
firms. When transactions take place within a firm they may be cheaper and
hence such savings decrease the total cost of production of an output. In other
words, the existence of firms could be explained by the fact that it saves
transaction costs.

However, the size of the firm has to be limited because as the firms grow
larger, a point is reached where the cost of internal transaction becomes equal
to or greater than the cost of transaction between firms. When such a stage is
reached, it puts a limit to the size of the firm. Further, the cost of supplying
additional services like legal, medical etc. within the firm exceeds the cost of
purchasing these services from other firms; as such services may be required
occasionally.

Let us consider the size of different kinds of firms around us and try to
understand the reasons for such differences. Why are service firms generally
smaller than capital-intensive firms like steel and automobile producing
companies What is the reason that a number of firms are choosing the BPO
route? A part of the explanation must lie in the fact that it is cheaper to
outsource than to absorb that activity within the firm. Consider a firm that
needs to occasionally use legal service. Under what conditions will it choose
23
Introduction to to hire a full time lawyer and take her on its rolls and under what conditions T
Managerial Economics will the firm outsource the legal activity or hire legal services on a case-by- O
case basis. Naturally, the answer depends upon the frequency of use for legal
services. The transaction cost framework demonstrates that the firm will
contract out if the cost of such an arrangement is lower and will prefer in-
house legal staff when the opposite is true.

Firms are classified into different categories as follows:

a) Private sector firms.
b) Public sector firms.
c) Joint sector firms.
d) Non-profit firms.

Figure 2.1: Interdependence of Consumers and Firms

Firms can also be classified on the basis of number of owners as:

a) One Person Company.

b) Partnership.
c) Corporations

Some firms mentioned below are different from above. They may provide
service to a group of clients for example, patients or to a group of its
members only.

a) Universities.
b) Public Libraries.
c) Hospitals.
d) Museums.
e) Churches.
f) Voluntary Organisations.
g) Cooperatives.
h) Unions.
i) Professional Societies, etc.

The concept of a firm plays a central role in the theory and practice of
managerial economics. It is, therefore, valuable to discuss the objectives of a
firm.
24
 The Firm: Stakeholders,
2.2 OBJECTIVE OF THE FIRM Objectives and Decision
Issues
The traditional objective of the firm has been profit maximization. It is still
regarded as the most common and theoretically the most plausible objective
of business firms. We define profits as revenues less costs. But the definition
of cost is quite different for the economist than for an accountant. Consider
an independent businessperson who has an MBA degree and is considering
investing `1 lakh in a retail store that s/he would manage. There are no other
employees. The projected income statement for the year as prepared by an
accountant is as shown below:

Sales `90,000
Less: Cost of Goods Sold `40,000
Gross Profit: `50,000
Less:
Advertising `10,000
Depreciation `10,000
Utilities `3,000
Property Tax `2,000
Misc. `5,000 =`30,000
Net Accounting Profit `20,000

This accounting or business profit is what is reported in publications and in

the quarterly and annual financial reports of businesses.

The economist recognizes other costs, defined as implicit costs. These costs
are not reflected in cash outlays by the firm, but are the costs associated with
foregone opportunities. Such implicit costs are not included in the accounting
statements but must be included in any rational decision making framework.
There are two major implicit costs in this example. First, the owner has `1
lakh invested in the business. Suppose the best alternative use for the money
is a bank account paying a 10 per cent interest rate. This risk less investment
would return `10,000 annually. Thus, `10,000 should be considered as the
implicit or opportunity cost of having `1 lakh invested in the retail store.

Let us consider the second implicit cost, which includes the manager’s time
and talent. The annual wage return on an MBA degree may be taken as
`35,000 per year. This is the implicit cost of managing this business rather
than working for someone else. Thus, the income statement should be
amended in the following way in order to determine the economic profit:

Sales `90,000
Less: Cost of Goods Sold `40,000
Gross Profit: `50,000
Less:
Advertising `10,000
Depreciation `10,000
Utilities `3,000
Property Tax `2,000
Misc. `5,000 =`30,000

Accounting Profit `20,000

25
Introduction to Less: Implicit Costs: T
Managerial Economics Return on ` 1 lakh O
of capital `10,000
Foreign Wages `35,000 =`45,000
Net “Economic Profit” `25,000

Looking at this broader perspective, the business is projected to lose `25,000

in the first year. ` 20,000 accounting profit disappears when all relevant costs
are included. Another way of looking at the problem is to assume that `1 lakh
had to be borrowed at, say, 10 per cent interest and an MBA graduate hired at
`35,000 per year to run the store. In this case, the implicit costs become
explicit and the accounting made explicit. Obviously, with the financial
information reported in this way, an entirely different decision might be made
on whether to start this business or not.

Thus, we can say that economic profit equals the revenue of the firm minus
its explicit costs and implicit costs. To arrive at the cost incurred by a firm, a
value must be put to all the inputs used by the firm. Money outlays are only a
part of the costs. As stated above, economists also define opportunity cost.
Since the resources are limited, and have alternative uses, you must sacrifice
the production of a good or service in order to commit the resource to its
present use. For example, if by being the owner manager of your firm, you
sacrifice a job that offers you ` 2,00,000 per annum, then two lakhs is your
opportunity cost of managing the firm. Similarly, if Suresh Kumar was not
playing cricket, he could have earned a living (perhaps, not such a good one!)
by being a cricket commentator. Suresh’s opportunity cost of playing cricket
is the amount he could have earned being a cricket commentator.

The assignment of monetary values to physical inputs is easy in some cases

and difficult in others. All economic costing is governed by the principle of
opportunity cost. If the firm maximizes profits, it must evaluate its costs
according to the opportunity cost principle. Assigning costs is straightforward
when the firm buys an input on a competitive market. Suppose the firm
spends ` 20,000 on buying electricity. For its factory, it has sacrificed claims
to whatever else Rs 20,000 can buy and thus the purchase price is a
reasonable measure of the opportunity cost of using that electricity. The
situation is the same for hired factors of production. However, a cost must be
assigned to factors of production that the firm neither purchases, nor hires
because it already owns them. The cost of using these inputs is implicit costs
and has to be imputed. Implicit costs arise because the alternative
(opportunity) cost doctrine must be applied to the firm. The profit calculated
after including implicit as well as explicit costs in total cost is called
economic profit.

Profit plays two primary roles in the free-market system. First, it acts as a
signal to producers to increase or decrease the rate of output, or to enter or
leave an industry. Second, profit is a reward for entrepreneurial activity,
including risk taking and innovation. In a competitive industry, economic
profits tend to be transitory. The achievement of high profits by a firm
usually results in other firms increasing their output of that product, thus
reducing price and profit. Firms that have monopoly power may be able to
earn above-normal profits over a longer period; such profit does not play a
socially useful role in the economy.
26
Although, profit maximization is a dominant objective of the firm, other The Firm: Stakeholders,
important objectives of the firm, other than profit maximization that we will Objectives and Decision
discuss in this unit are: Issues

1. Maximization of sales revenue.

2. Maximization of firm’s growth rate
3. Maximization of manager’s own utility or satisfaction
4. Making a satisfactory rate of profit.
5. Long-run survival of the firm
6. Entry-prevention and risk avoidance.

Activity 3

a) “Among the various objectives of a modern firm, profit maximization

is the most important”. Comment.
................................................................................................................
................................................................................................................
................................................................................................................
................................................................................................................
b) Outline the circular flow of economic activity between individuals
and firms.
................................................................................................................
................................................................................................................
................................................................................................................
................................................................................................................

c) (i) .................................. profit is a cost of doing business and is the

amount by which .................................. exceeds ..................................
profit.

(ii) When a firm earns just a normal rate of return,................................

equals total economic cost and .................................. profit is zero.

d) A firm collects ` 1.75 lakhs in revenue and spends ` 80 thousands on

raw materials in a year. The owners of the firm have provided ` 5
lakhs of their own money to the firm instead of investing the money
and earning a high rate of interest.

(i) The firm earns economic profit of ............................ The firms

normal profit is ..........................................................................
(ii) The firm’s accounting profit is ..................................................
(iii) If the firm’s costs stay the same but its revenue falls to ............
only a normal profit is earned.

2.3 VALUE MAXIMIZATION

Most firms have sidelined short-term profit as their objective. Firms are often
found to sacrifice their short-term profit for increasing the future long-term
profit. Thus, the theory states that the objective of a firm is to maximize
wealth or value of the firm. For example, firms undertake research and
development expenditure, expenditure on new capital equipment or major
marketing programmes which require expenditure initially but are meant to
27
Introduction to generate future profits. The objective of the firm is thus to maximize the T
Managerial Economics present or discounted value of all future profits and can be stated as: O

……
1 1 1

Where, PV = Present Value of all expected future profits of the firm.

…. = Expected profit in 1, 2........................n years.
r = Appropriate discount rate
t = Time period 1 ……….n.

Assumed profit is equal to total revenue (TR) minus total cost (TC), then the
value
of the firm can also be stated as:
TR TC
Value of the irm
1 r

Thus maximizing the discounted value of all future profits is equivalent to

maximizing the value of the firm.

A careful inspection of the equation suggests how a firm’s managers and

workers can influence its value. For example, in a company, the marketing
managers and sales representatives work hard to increase its total revenues,
while its production managers and manufacturing engineers strive to reduce
its total costs. At the same time, its financial managers play a major role in
obtaining capital, and hence influence the equation, while its research and
development personnel invent and reduce its total costs. All of these diverse
groups affect the company’s value, defined here as the present value of all
expected future profits of the firm.

Figure 2.2: Determination of the value of the firm

28
 The Firm: Stakeholders,
2.4 ALTERNATIVE OBJECTIVES OF THE Objectives and Decision
FIRMS Issues

Economists have also examined other objectives of firms. We shall discuss

some of them here. According to Baumol, most managers will try to
maximize sales revenue. There are many reasons for this. For example, the
salary and other earnings of managers are more closely related to sales
revenue than to profits. Banks and financers look at sales revenue while
financing the corporation. The sales revenue trend is a readily available
indicator of performance of the firm. Growth in sales increases the
competitive strength of the firm. However, in the long run, sales
maximization and profit maximization may converge into one objective.

Another economist Robin Marris assumes that owners and managers have
different utility functions to maximize. The manager’s utility function (Um)
and Owner’ utility functions (Uo) are:

Um = f (Salary, job, power, prestige, status)

Uo = f (Output, capital, profit, share)

By maximizing the variables, managers maximize both their own utility

function and that of the owners. Most of the variables of both managers and
owners are correlated with a single variable, namely, the size of the firm.
Maximization of these variables depends on the growth rate of the firm.
Thus, Marris argues that managers will attempt to maximize growth rate of
firms. However, this objective does not completely discard the profit
maximization objective.

According to Oliver Williamson, managers seek to maximize their own

utility function subject to a minimum level of profit. The utility function
which managers seek to maximize include both quantifiable variables like
salary and slack earnings and non-quantifiable variables like power, status,
security of job, etc. The model developed by Cyert-March focuses on
satisficing behaviour of managers. The firm has to deal with an uncertain
business world and managers have to satisfy a variety of groups-staff,
shareholders, customers, suppliers, authorities, etc. All these groups have
often-conflicting interests in the firm. In order to reconcile between the
conflicting interests and goals, managers form an aspiration level of the firm
combining the following objectives – production, sales and market share,
inventory and profit. The aspiration levels are modified and revised on the
basis of achievements and changing business environment.

As is true with most economic models, the application will depend upon the
situation and one cannot say that a particular model is better than the other. In
general, one can assert that the profit maximising assumption seems to be a
reasonable approximation of the real world, although in certain cases there
might be a deviation from this objective.
29
Introduction to T
Managerial Economics
2.5 GOALS OF REAL WORLD FIRMS O

By now we know that firms that maximize profits are not just concerned
about short-run profits, but are more concerned with long-term profits. They
may not take full advantage of a potential monopolistic situation, for
example, many stores have liberal return policies; many firms spend millions
on improving their reputation and want to be known as ‘good’ citizens. The
decision maker’s income is often a cost of the firm. Most real-world
production takes place in large corporations with 8-9 levels of management,
thousands of stakeholders and boards of directors. Self-interested decision
makers have little incentive to hold down their pay. If their pay is not held
down, firm’s profit will be lower. Most firms manage to put some pressure on
managers to make at least a pre-designated level of profit.

In the modern corporation, the owners or stakeholders (i.e. the principals)

hire managers (i.e., agents) to conduct the day-to-day operations of the firm.
These managers are paid a salary to represent the interest of the owners,
ostensibly, to maximize the value of the firm. A board of directors is elected
by the owners to meet regularly with the managers to oversee their activity
and to try to ensure that the managers are, in fact, acting in the best interest of
the owners.

Because of the difficulty of monitoring the managers on a continual basis, it

is possible that goals other than profit-maximization may be pursued. In
addition to those mentioned earlier, the managers may seek to enhance their
positions by spending corporate funds on fancy offices, excessive and
expensive travel, club memberships, and so forth. In recent years, many
corporations have taken action to align the interests of owners with the
interests of the managers by tying a large share of managerial compensation
to the financial performance of the firm.

For example, the manager may be given a basic salary plus potentially large
bonuses for meeting such goals as attaining a specified return on capital,
growth in earnings, and/or increase in the price of the firm’s stock. With
regard to the latter, the use of stock options awarded to top managers is a
most effective way to ensure that managers act in the interest of the
shareholders. Typically, the arrangement provides that the manager is to
receive an option to buy a specified number of shares of common stock at the
current market price for a specified number of years. The only way the
executives can benefit from such an arrangement is if the price of stock rises
during the specified term. The option is exercised by buying the shares at the
specified price, and the gain equals the increase in share price multiplied by
the number of shares purchased. Sometimes the agreement specifies that the
stock must be held for several years following purchase. Essentially, this
option arrangement makes the manager a de facto owner, even if the option
has not been exercised. In almost every case of a report of unusually high
executive compensation, the largest part of that compensation is associated
with gains from stock options.

Emergence of oligopoly, a market structure characterized by the existence of

a few large firms, mergers and amalgamations have made the structure of
industries concentrated so that few large (dominant) firms account for a
30 major portion of an industry’s output. This shifts the pressure on each firm to
maximize profit independently and leads to joint profit maximizations The Firm: Stakeholders,
through cartels and collusions. Profit maximization may not be the only Objectives and Decision
inevitable objective. Issues

India’s Global Companies and their Objectives: One of the most

significant business and economic trends of the late twentieth century is the
rise of ‘global’ or ‘stateless’ corporation. The trends toward global companies
are unmistakable and are accelerating. The sharpest weapon that a
corporation can develop to survive and thrive, in the globalised market place
is competitiveness. Its corner stone as articulated by strategy guru Michael
Porter is its ability to create more value on a sustainable basis, for the
customer than its rivals can.

Many Indian corporations such as an Indian multinational conglomerate

Pharmaceutical company among others are competing on the world stage.
Whatever product or service a company offers it must meet the customers
wants in the most satisfactory manner. This should be the aim of the
company. The competitiveness of Company in the global market place comes
from both quality and scale. The challenge is to remain at the top. That
challenge is linked with productivity. Pharmaceutical Company's greatest
strength lies in the fact that it is strongly backward integrated. It helps them
manage cost across the entire value chain making them extremely cost
competitive. Cost leadership is a function of scale and technology. By
upgrading technology, Pharmaceutical Company's could continue to be a cost
leader. A company has to continuously upgrade itself on several parameters:
production efficiency, product development, quality management and
marketing skills.

This competitiveness - defined by Michael Porter as the sustained ability to

generate more value for customers than the cost of creating that value. Many
new entrepreneurs and new industries are emerging who are able to operate
successfully in this changed environment

2.6 FIRM’S CONSTRAINTS

Decision-making by firms takes place under several restrictions or
constraints, such as:

Resource Constraints: Many inputs may be available in a limited or fixed

quantity e.g., skilled workers, imported raw material, etc.

Legal Constraints: Both individuals and firms have to obey the laws of the
State as well as local laws. Environmental laws, employment laws, disposal
of wastes are some examples.

Moral Constraints: These imply to actions that are not illegal but are
sufficiently consistent with generally accepted standards of behaviour.

Contractual Constraints: These bind the firm because of some prior

agreement such as a long-term lease on a building or a contract with a labour
union that represents the firm’s employees. 31
Introduction to Decision-making under these constraints with optimal results is a T
Managerial Economics fundamental part of managerial economics. O

2.7 BASIC FACTORS OF DECISION-MAKING:

THE INCREMENTAL CONCEPT
Incremental reasoning involves estimating the impact of decision alternatives.
The two basic concepts in the incremental analysis are:

Incremental Cost (IC)

Incremental Revenue (IR)

Incremental cost is defined as the change in total cost as a result of change in

the level of output, investment etc. Incremental revenue is defined as the
change in total revenue resulting from a change in the level of output, prices
etc. A manager always determines the worth of a decision on the basis of the
criterion that IR>IC.

A decision is profitable if

 it increases revenue more than it increases cost

 it reduces some costs more than it increases others
 it increases some resources more than it decreases others
 it decreases costs more than it decreases revenues.

To illustrate the above points, let us take a case where a firm gets an order
that can get it additional revenue of ` 2,000. The normal cost of production of
this order is–

Labour : ` 600
Materials : ` 800
Overheads : ` 720
Selling and administration expenses : ` 280
Full cost : ` 2,400

Comparing the additional revenue with the above cost suggests that the order
is unprofitable. But, if some existing facilities and underutilized capacity of
the firm were utilized, it would add much less to cost than ` 2,400. For
example, let us assume that the addition to cost due to this new order is, say,
the following:

Labour : ` 400
Materials : ` 800
Overheads : ` 200
Total incremental Cost : ` 1,400

In the above case the firm would earn a net profit of ` 2000 – ` 1400 = ` 600,
while at first it appeared that the firm would make a loss of ` 400 by
32 accepting the order.
The worth of such a decision can be judged on the basis of the following The Firm: Stakeholders,
theorem. Objectives and Decision
Issues
Theorem I: A course of action should be pursued upto the point where its
incremental benefits equal its increment costs.

According to the theorem, the firm represented in Table 2.1 will produce only
seven units of output as its Marginal Revenue (MR)= Marginal Cost (MC)1 at
that level of output. As can be calculated from the Table, the MC of 8th unit
is more than its MR. Hence the firm gets negative profit from 8th unit and
thus is advised not to produce it.

The acceptance or rejection of an order by a firm for its product depends on

whether the resultant costs are greater or less than the resultant revenue. If
these principles are not followed, the equilibrium position would be
disturbed. But the problem with the concept of marginalism is that the
independent variable may be subject to “bulk changes” instead of “unit
changes”. For example, a builder may not change one labourer at a time, but
many of them together. Similarly, the output may change because of a change
in process, pattern or a combination of factors, which may not always be
measured in unit terms. In such cases, the concept of marginalism is changed
to incrementalism. Or, in other words, incrementalism is more general,
whereas marginalism is more specific. All marginal concepts are incremental
concepts, but all incremental concepts need not be marginal concepts.

Table 2.1 : Profit Function of a Firm

Unit of Total Total Cost Total Profit Average Marginal

Output Revenue Profit Profit

1 2 3 4 5 6
1 20 15 5 5.0 -
2 40 29 11 5.5 6
3 60 42 18 6.0 7
4 80 52 28 7.0 10
5 100 65 35 7.0 7
6 120 81 39 6.5 4
7 140 101 39 5.6 0
8 160 125 35 4.4 -4

2.8 THE EQUI-MARGINAL PRINCIPLE

According to this principle, different courses of action should be pursued
upto the point where all the courses provide equal marginal benefit per unit of
cost. It states that a rational decision-maker would allocate or hire his
resources in such a way that the ratio of marginal returns and marginal costs
of various uses of a given resource or of various resources in a given use is
the same. For example, a consumer seeking maximum utility (satisfaction)
1
Marginal Revenue is the additional revenue from selling one more unit, while Marginal
Cost is the additional cost of producing one more unit. 33
Introduction to from his consumption basket, will allocate his consumption budget on goods T
Managerial Economics and services such that O

/ = / = ………= /
Where = marginal utility from good one,
= marginal cost of good one and so on,

Similarly, a producer seeking maximum profit would use the technique of

production (input-mix.) which would ensure

/ = / = ……… /

Where = Marginal revenue product of input one (e.g. Labour),

= Marginal cost of input one and so on.

It is easy to see that if the above equation was not satisfied, the decision
makers could add to his utility/profit by reshuffling his resources/input e.g. if
/ > / the consumer would add to his utility by buying more
of good one and less of good two. Table 2.2 summarizes this principle for
different sellers.

Example: A multi-commodity consumer wishes to purchase successive units

of A, B and C. Each unit costs the same and the consumer is determined to
have a combination including all the three items. His budget constraint is
such that he cannot buy more than six units in all. Again, he is subject to
diminishing marginal utility i.e. as he has more of an item, he wants to
consume less of it. Table 2.3 shows the optimization example:

Table 2.2: The Equi-Marginal Principle

Unit Equi-Marginal Principle

Multi-market seller = = = ……………
Multi-plant monopolist = = = ……………
Multi-factor employer = = = ……………
Multi-product firm = = = ……………
Multi-commodity consumer = = = ……………

MR=marginal revenue; MC=marginal cost; MP=marginal product;

Mπ=marginal profit; MU=marginal utilities.

Table 2.3 : Optimization Example

MARGINAL UTILITES
Units Item A Item B Item C
1 10 9 8
2 9 8 7
3 8 7 6
4 7 6 5
5 6 5 4
6 5 4 3
34
The utility maximizing consumer will end up with a purchase of 3A+2B+1C The Firm: Stakeholders,
because that combination satisfies equi-marginalism: Objectives and Decision
Issues

= = =8

In the real world, often the equi-marginalism concept has to be replaced by

equi-incrementalism. This is because, changes in the real world are discrete
or lumpy and therefore the concept of marginal change may not always
apply. Instead, changes will be incremental in nature, but the decision rule or
optimizing principle will remain the same

2.9 THE DISCOUNTING PRINCIPLE

Many transactions involve making or receiving cash payments at various
future dates. A person who takes a house loan trades a promise to make
monthly payments for say, fifteen or twenty years for a large amount of cash
now to pay for a home. This case and other similar cases relate to the time
value of money. The time value of money refers to the fact that a rupee to be
received in the future is not worth a rupee today. Therefore, it is necessary to
have techniques for measuring the value today (i.e., the present value) of
rupees to be received or paid at different points in the future. This section
outlines the approach to analyzing problems that involve payment and/or
receipt of money at one or more points in time.

One may ask how much money today would be equivalent to ` 100 a year
from now if the rate of interest is 5%. This involves determining the present
value of ` 100 to be received after one year. Applying the formula –

100
1.05

we obtain ` 95.24,

` 95.24 will accumulate to an amount exactly equal to ` 100 in one year at

the interest rate of 5 per cent. Looked at another way, you will be willing to
pay maximum of ` 95.24 for the benefit of receiving ` 100 one year from
now if the prevailing interest rate is 5 per cent.

The same analysis can be extended to any number of periods. A sum of ` 100
two years from now is worth:

100
1.05

= `90.70 today.

In general, the present value of a sum to be received at any future date can be
found by the following formula:

1
35
Introduction to PV = present value, Rn = amount to be received in future, i = rate of interest, T
Managerial Economics n = number of years lapsing between the receipt of R. O

If the receipts are made available over a number of years, the formula
becomes:

….
1 1 1 1

In the above formula if = , = etc., it becomes an ‘annuity’. An

annuity has been defined as series of periodic equal payments. Although the
term is often thought of in terms of a retirement pension, there are many other
examples of annuities. The repayment schedule for a home loan is an annuity.
A father’s agreement to send his son ` 1000 each month while he is in
college is another example. Usually, the number of periods is specified, but
not always. Sometimes retirement benefits are paid monthly as long as a
person is alive. In other case, the annuity is paid forever and is called
‘perpetuity.’

It must be emphasized that the strict definition of an annuity implies equal

payments. A contract to make 20 annual payments, which increase each year
by, say, 10 per cent, would not be an annuity. As some financial
arrangements provide for payments with periodic increase, care must be
taken not to apply an annuity formula if the flow of payments is not a true
annuity.

The present value of an annuity can be thought of as the sum of the present
values of each of several amounts. Consider an annuity of three ` 100
payments at the end of each of the next three years at 10 percent interest. The
present value of each payment is

1
100
1.10
1
100
1.10
1
100
1.10

and the sum of these would be

1 1 1
100 100 100
1.10 1.10 1.10

OR

1 1 1
100
1.10 1.10 1.10
36
The present value of this annuity is The Firm: Stakeholders,
Objectives and Decision
PV = 100 (0.9091 + 0.8264 + 0.7513) = 100 (2.4868) = 248.68 Issues
Although this approach works, it clearly would be cumbersome for annuities
of more than a few periods. For example, consider using this method to find
the present value of a monthly payment for forty years if the monthly interest
rate is 1 per cent. That would require evaluating the present value of each of
480 amounts In general, the formula for the present value of an annuity of A
rupees per period for n periods and a discount rate of i is
1 1 1
⋯
1 1 1

2.10 THE OPPORTUNITY COST PRINCIPLE

The opportunity cost of anything is the return that can be had from the next
best alternative use. A farmer who is producing wheat can also produce
potatoes with the same factors. Therefore, the opportunity cost of a quintal of
wheat is the amount of the output of potatoes given up. The opportunity costs
are the ‘costs of sacrificed alternatives.’
Whenever the manager takes a decision he chooses one course of action,
sacrificing the other alternative courses. We can therefore evaluate the one,
which is chosen in terms of the other (next best) alternative that is sacrificed.
A machine can produce either X or Y. The opportunity cost of producing a
given quantity of X is the quantity of Y which it would have produced.
The opportunity cost of holding `1000 as cash in hand for one year is the
10% rate of interest, which would have been earned had it been invested in
the form of fixed deposits in the bank.
 all decisions which involve choice must involve opportunity cost
calculation,
 the opportunity cost may be either real or monetary, either implicit or
explicit, either non-quantifiable or quantifiable.
Opportunity costs’ relevance is not limited to individual decisions.
Opportunity costs are also relevant to government’s decisions, which affect
everyone in society. A common example is the guns-versus-butter debate.
The resources that a society has are limited; therefore its decisions to use
those resources to have more guns (more weapons) means that it must have
less butter (fewer consumer goods). Thus when society decides to spend 100
crore on developing a defence system, the opportunity cost of that decision is
100 crores not spent on fighting drugs, helping the homeless, or paying off
some of the national debt.
For the country as a whole, the production possibility reflects opportunity
costs. Figure 2.1 shows the Production Possibility Curve (PPC) reflecting the
different combinations of goods, which an economy can produce, given its
state of technology and total resources. It illustrates the menu of choices open
to the economy. Let us take the example that the economy can produce only
two goods, butter and guns. The economy can produce only guns, only butter
or a combination of the two, illustrating the tradeoffs or choice inherent in
such a decision. The opportunity cost of choosing guns over butter increases
as the production of guns is increased. The reason is that some resources are
relatively better suited to producing guns. The quantity of butter, which has
to be sacrificed to produce an additional unit of guns, is called the 37
Introduction to opportunity cost of guns (in terms of butter). Due to the increasing T
Managerial Economics opportunity cost of guns, the PPC curve will be concave to the origin. O
Increasing opportunity cost of guns means that to produce each additional
unit of guns, more and more units of butter have to be sacrificed. The basis
for increasing opportunity costs is the following assumptions:
i) Some factors of production are more efficient in the production of
butter and some more efficient in production of guns. This property of
factors is called specificity. Thus specificity of factors of production
causes increasing opportunity costs.

Figure 2.1: Production Possibility Curve

Figure 2.2: Production Possibility Curve - Linear

38
ii) The production of the goods require more of one factor than the other. The Firm: Stakeholders,
For example, the production of guns may require more capital than Objectives and Decision
that of butter. Hence, as more and more of capital is used in the Issues
manufacture of guns, the opportunity cost of guns is likely to increase.

Let us assume that an economy is at point A where it uses all its resources in
the production of butter. Starting from A, the production of 1 unit of guns
requires that AC units of butter be given up. The production of a second unit
of guns requires that additional CD units of butter be given up. A third
requires that DE be given up, and so on. Since DE>CD>AC, and so on, it
means that for every additional unit of guns more and more units of butter
will have to be sacrificed, or in other words, the opportunity cost keeps on
increasing.

The opportunity cost of the first few units of guns would initially be low and
those resources, which are more efficient in the production of guns move
from, butter production to gun production. As more and more units of guns
are produced, however, it becomes necessary to move into gun production,
even for those factors, which are more efficient in the production of butter.
As this happens, the opportunity cost of guns gets larger and larger. Thus,
due to increasing opportunity costs the PPC is concave.

If the PPC curve were to be a straight line, the opportunity cost of guns
would always be constant. This would mean equal (and not increasing
amounts of butter) would have to be forgone to produce an additional unit of
guns. The assumption of constant opportunity costs is very unrealistic. It
implies that all the factors of production are equally efficient either in the
production of butter or in the production of guns.

For many of the choice society make opportunity costs tend to increase as we
choose more and more of an item. Such a phenomenon about choice is so
common, in fact, that it has acquired a name: the principle of increasing
marginal opportunity cost. This principle states that in order to get more of
something, one must give up ever-increasing quantities of something else. In
other words, initially the opportunity costs of an activity are low, but they
increase the more we concentrate on that activity.

2.11 THE INVISIBLE HAND

Adam Smith, the father of modern economics believed that there existed an
“invisible hand” which ruled over the economic system. According to him
the economic system, left to itself, is self-regulating. The basic driving force
in such a system is trying to enhance its own economic well-being. But the
actions of each unit, acting according to its own self-interest, are also in the
interests of the economy as a whole.

Producers are led by the profit motive to produce those goods and services
which the consumers want. They try to do this at the minimum possible cost
in order to maximize their profits. Moreover, if there is competition among a
number of producers, they will each try to keep the price of their product low
in order to attract the consumers. The goods produced are made available in
the market by traders. They also act in their own self-interest. However, in a
self-regulating economy, there is rarely any shortage of goods and services. 39
Introduction to Decisions to save and invest are also taken by the individual economic units. T
Managerial Economics For example, households save some of their income and deposit part of it in O
the banks, or invest it in shares and debentures and so on. The producers
borrow from the banking system and also issue shares and debentures to
finance their investments. In turn, they reinvest a part of their profits.

All the economic functions have been carried out by individuals acting in
isolation. There is no government or centralized authority to determine who
should produce what and in what quantity, and where it should be made
available. Yet in a self-regulating economy there is seldom a shortage of
goods and services. Practically everything you want to buy is available in the
market. Thus according to Adam Smith, the economic system is guided by
the “invisible hand”. In a more technical way we can say that the basic
economic problems in a society are solved by the operation of market forces.

2.12 SUMMARY
There is a circular flow of economic activity between individuals and firms
as they are highly interdependent. The firms’ existence is based on manifold
reasons. Firms are classified into different categories. Different firms
belonging to the same industry, facing the same market environment, behave
differently. Thus, the necessity for theories of the firm. Profit is defined as
revenues minus costs. But the definition of cost is quite different for
economist than for the accountant. Short-term profit has been sidelined by
most firms as their objective for increasing the future long-term profit. Real
world firms often have a set of complicated goals. The basic factors of
decision making can be outlined by various principles.

2.13 SELF-ASSESSMENT QUESTIONS

1. Write notes in about 200 words on the following:

a) The incremental concept

b) Opportunity cost
c) Scope of managerial economics
d) The Invisible Hand

2. ‘Managerial Economics serves as a link between traditional

economics and decision sciences for business decision-making.’
Elucidate.

3. Calculate, using the best estimates you can make:

a) Your opportunity cost of attending college.

b) Your opportunity cost of taking this course.
c) Your opportunity cost of attending yesterday’s lecture of your
course.

4. The following is the hypothetical production possibility table of India:

40
 Resources Devoted to Output of Clothing Output of Food The Firm: Stakeholders,
Clothing Objectives and Decision
100% 20 0 Issues
80% 16 5
60% 12 9
40% 8 12
20% 4 14
0% 0 15

a) Draw India’s production possibility curve.

b) What is happening to marginal opportunity costs as output of
food increases?
c) If the country gets better at the production of food, what will
happen to the production possibility curve?

If the country gets equally better at producing food and producing

clothing, what will happen to the production possibility curve?

5. Use the following interest rates for government bonds for the risk-free
discount rate and answer the following:

Time of Maturity (years) Interest Rate (%)

1 5.75
2 6.00
3 6.25
4 6.50
5 6.75

a) Calculate the PV of a ` 1 lakh payment to be received at the

end of one year, 2 years, 3 years, 4 years and 5 years.

b) What is the present value of a firm with a 5 years life span that
earns the following stream of expected profit at the year-end?

Years Expected Profit (in Crores)

1 10
2 20
3 50
4 25
5 50

6. Value maximization has become the major objective of a modern

firm. Comment.

2.14 FURTHER READINGS

Dean, J. (1951). Managerial Economics. PrenticeHall.
Mote, V.L., Paul, S., & Gupta, G.S. (2016). Mangerial Economics Concepts
and Cases, Tata McGraw-Hill, New Delhi.
Koutsoyiannis, A. (2018). Modern Microeconomics (2nd Ed.). Macmillan
Publishers India Pvt. Ltd.
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