Managerial Economics

Q1. What is Managerial Economics? Explain the nature and scope of Managerial Economics.

Ans. Managerial Economics generally refers to the integration of economic theory with business practice. While
economics provides the tools which explain various concepts such as Demand, Supply, Price, Competition
etc., Managerial Economics applies these tools to the management of business. In this sense, Managerial
Economics is also understood to refer to business economics or applied economics.

Definitions of Managerial Economics

According to Prof. Spencer Sigelman, Managerial Economics deals with integration of economic theory
with business practice for the purpose of facilitating decision making and forward planning by management.

According to Prof. Hauge, Managerial Economics is concerned with using logic of economics,
mathematics & statistics to provide effective ways of thinking about business decision problems.

According to Prof. Joel Dean, The purpose of Managerial Economics is to show how economic analysis
can be used in formulating business policies.

Nature of Managerial Economics:

1. Managerial Economics aims at providing help in decision-making by firms. For this purpose, it draws
heavily on the propositions of microeconomic theory. The concepts of microeconomics used frequently
in managerial economics are marginal cost, marginal revenue, elasticity of demand, market structures
and their significance in pricing policies, etc. Some of these concepts however provide only the logical
base and have to be modified in practice.
2. Macroeconomics assists firms in forecasting. Macroeconomics indicates the relationship between (i)
the magnitude of investments and level of national income, (ii) the level of national income and the
level of employment, (iii) the level of consumption and the national income, etc. The postulates of
macro economics can be used to identify the level of demand at some future point of time, based on the
relationship between the level of national income and the demand for a particular product.
3. Managerial Economics is decidedly applied branch of knowledge. Therefore, the emphasis is laid on
these propositions which are likely to be useful to the management.
4. Managerial Economics is prescriptive in nature and character. It recommends that it should be done
under alternative conditions. Thus, managerial economics is one of the normative sciences and reflects
upon the desirability or otherwise of the propositions.
5. Managerial Economics, to the extent that it uses economic thought, is a science, but it is an applied
science. Economic thought uses deductive logic (if X is true, then Y is true.) To have confidence in the
findings, the propositions deducted are subjected to empirical verification. Furthermore, there is an
attempt to generalize the propositions which provide a predictive character.

Scope of Managerial Economics

The scope of Managerial Economics is so wide that it embraces almost all the problems and areas of the
manager and the firm. It deals with demand analysis and forecasting, resource allocation, production
function, cost analysis, inventory management , advertising, price system, capital budgeting etc.

1. Demand Analysis and forecasting: It analyses carefully and systematically the various types of
demand which enable the manager to arrive at a reasonable estimate of demand for products of his
company. He takes into account such concepts as income elasticity and cross elasticity. When demand
is estimated, the manager does not stop at the stage of assessing the current demand but estimates future
demand as well. This is what is meant by demand forecasting.
2. Production Function: The resources are scarce and also have alternative uses. Inputs play a
vital role in the economics of production. The factors of production, otherwise called inputs, may be

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 combined in a particular way to yield the maximum output. Alternatively, when the price of inputs
shoot up, a firm is forced to work out a combination of inputs so as to ensure that this combination
becomes least cost combination. In this way, the production function is pressed into service by
managerial economics.
3. Cost Analysis: Cost analysis is yet another area studied by managerial economics. For instance,
determinants of cost, methods of estimating costs, the relationship between cost and output, the forecast
of cost and profit – these are very vital to a firm. Managerial Economics touches these aspects of cost-
analysis, an effective knowledge and application of which is cornerstone for the success of a firm.
4. Inventory Management: An inventory refers to stock of raw materials which a firm keeps. Now
the problem is how much of the inventory is ideal stock. If it is high, capital is unproductively tied up,
which might, if the stock of inventory is reduced, be used for other productive purposes. On the other
hand, if level of inventory is low, production will be hampered. Therefore, managerial economics will
use such methods as ABC analysis, a simple simulation exercise and some mathematical models with a
view to minimize the inventory cost. It also goes deeper into such aspects as the need for inventory
control; It classifies inventories and discusses the costs of carrying them.
5. Advertising: It may sound strange when we say that advertising is an area which managerial economics
embraces. While the copy, illustration, etc. of an advertisement are the responsibility of those who get it
ready for the press, the problems of cost, the methods of determining the total advertisement costs and
budget, the measuring of the economic effects of advertising – these are the problems of the manager.
To produce a commodity is one thing; to market it is another. Yet the message about the product should
reach the consumer before he thinks of buying it. Therefore advertising forms an integral part of
decision-making and forward planning.
6. Price System: The pricing system as a concept was developed by economics and it is widely
used in managerial economics. The central functions of an enterprise are not only production but
pricing as well. While the cost of production has to be taken into account while pricing a commodity, a
complete knowledge of the price system is quite essential to determination of price. Pricing is actually
guided by considerations of cost plus pricing and the policies of public enterprises. Further, there is
such a thing as price leadership and non-price competition. Price system touches upon several aspects
of managerial economics and aids or guides the manger to take valid and profitable decisions.
7. Resource Allocation: Scarce resources obviously have alternate uses. How best can these scarce
resources be allocated to competing needs? The aim of course is to achieve optimization. For this
purpose some advanced tools like linear programming are used to arrive at the best course of action for
a specified end.
8. Capital Budgeting: This is another area which calls for a thorough understanding on the part of the
manager if he is to arrive at meaningful decisions. Capital is scarce, and it costs something. Now the
problem is how to arrive at the cost of capital; how to ensure that capital becomes rational; how to face
up to budgeting problems; how to arrive at investment decisions under conditions of uncertainty; how to
effect a cost-benefit analysis.

Q2. Briefly review various theories of profit.

Ans. Various theories have been developed to explain the emergence of profit.

1. Risk Taking theory: The Risk-Taking Theory was developed by the American economist Hawley.
According to him, profit arises because considerable amount of risk is involved in business. Profit is
therefore the reward for risk-taking. Hawley’s theory has been criticized on several grounds. In the
first place, Hawley has not classified the types of risks. Secondly, as Cawer has pointed out, profit is
not the reward for risk-taking. It is the reward for risk-avoiding. An entrepreneur is required to
minimize his risk if he cannot eliminate it totally. A successful entrepreneur is he who earns good
profits by eliminating the risk. On the other hand, a mediocre businessman is not able to reduce the risk
in business; and therefore is subjected to losses.
2. Uncertainty-Bearing Theory of profit: Uncertainty-Bearing Theory of profit was developed
by the American economist, Prof. F.H.Knight. He has classified the risks under the two heads.

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 • Certain risks such as risk of fire, risk of theft, risk of accident etc. are less important because
they can be passed on to an insurance company. An entrepreneur can take an insurance policy by
paying the premium. Since such risks are covered by insurance, they are called “Insurable Risks.”
• There are other risks which cannot be passed on to an insurance company or to the paid
managers. Every business involves great amount of uncertainty and the losses arising therefrom
cannot be estimated with precision. The prices of raw materials may suddenly increase, the
supply of raw materials may be restricted and introduction of new substitutes in the market may
reduce the demand for the product. When demand declines, large stocks may remain unsold in
the go-down. A producer may have to face keen competition, if the market is characterized by
monopolistic competition. All these factors are uncertain and losses arising therefrom cannot be
insured with any insurance company. These risks and losses must be borne by the entrepreneur
himself. According to Prof. Knight, profit is therefore the reward for uncertainty bearing.

Uncertainty theory has been criticized on the ground that profit is the reward paid to an entrepreneur
for discharging several duties. Prof. Knight has overlooked other duties and has glorified the
uncertainty; the theory has no sound foundations either in logic or in practice. A number of illiterate
producers who have not studied the theory, are able to anticipate precisely the profits or losses that
would arise in future.
3. Innovation Theory: Innovation theory was developed by Joseph Schumpeter. According to him,
profit is the reward paid to an entrepreneur for his innovative endeavors. Schumpeter has made
distinction between invention and innovation. A scientist may make an invention, but this invention is
exploited on a commercial basis by an entrepreneur. The basis on which the invention is exploited
depends upon the innovative nature of the entrepreneur. If he is successful in exploiting the invention it
is innovation. According to Schumpeter, profit is the reward for innovation. Schumpeter’s theory has
been criticized on several grounds. Profit is the reward for discharging so many duties; but Schumpeter
has overlooked the other duties. Another point of criticism is that Schumpeter has neglected the fact
that profit is also the reward for risk and uncertainty bearing. The most serious criticism of this theory
is that a particular producer who exhibits an innovative character may earn super normal profits in the
short run. But the super normal profits will attract new firms to the industry. If new firms enter the
industry, the super normal profits would be shared between the existing as well as the new firms. In the
long run, super normal profits would, therefore, disappear. It is said that profits are caused by
innovation and disappear by imitation. Schumpeter’s theory is therefore to be taken to a limited extent.
4. Dynamic theory of Profit: The Dynamic theory of profit was developed by the renowned
economist, J.B. Clark. Prof. Clark points out that the whole world is dynamic. Changes after changes
are taking place every day; and the economic consequences of these changes are of a far reaching
character. Prof. Clark has pointed out the following types of changes.
• Changes in the quantity and Quality of human needs;
• Changes in the technique of production
• Changes in supply of capital
• Changes in organization of business
• Changes in population
These changes can occur at any time. Techniques of production may change and improved machinery may
be introduced. This may reduce the cost and increase the profit and output. But to purchase the improved
machinery, a larger amount of fixed capital is required. This may necessitate the admission of a new partner
or conversion of the partnership firm into a joint stock company to raise capital on a large scale. All these
changes can occur suddenly and an entrepreneur has to face them properly. A producer who overcomes
these hurdles is successful in earning higher profits. He must adjust himself to the changing times. A
producer who cannot address himself to the dynamic world lags behind. In order to survive and grow every
producer must change the methods to suit the changing needs. According to Prof. Clark, profit is the reward
paid for dynamism.

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Q3. State and explain the Law of Variable Proportion.
Ans. Statement of the Law:
1. As equal increments of one input are added; the inputs of other productive services being held, constant,
beyond a certain point the resulting increments of product will decrease, i.e., the marginal product will
diminish. (G. Stigler)

2. As the proportion of one factor in a combination of factors is increased, after a point, first the marginal
and then the average product of that factor will diminish. (F. Benham)

3. An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause
output to increase; but after a point the extra output resulting from the same additions of extra inputs
will become less and less. (P.A. Samulson)

Explanation of the Law of Diminishing Returns (Variable Proportion) with the help of a table:

Fixed Factor Variable Factor Total Product Average Product Marginal Product
K 1 5 5 5
K 2 15 7.5 10 Increasing Returns
K 3 30 10 15
K 4 50 12.5 20
K 5 70 14.0 20 Constant Returns
K 6 90 15 20
K 7 105 15 15
K 8 115 14.3 10
K 9 120 13.3 5
K 10 124 12.4 4 Diminishing Returns
K 11 127 11.5 3
K 12 127 10.50 0
K 13 118 9.07 -9 Negative Returns

Average Marginal Relationship:

The above table shows that eventually the total product also starts declining. But first to decline is the
marginal product. The relationship between them is as follows.

• As long as the average product is rising, marginal product would be larger than the average product.
• M.P. is less than A.P., when A.P. is decreasing.
• The A.P. remains constant when M.P. and A.P. are equal. Also, when A.P. is maximum M.P. equals
A.P.
• Total product is maximum when M.P. is zero.
• M.P. becomes negative when T.P. falls.
• In the table, when 1 to 4 workers are employed, the marginal product goes on increasing. This is the
phase of Increasing Returns.
• When workers 4,5 and 6 are employed, M.P. is constant i.e. 20. This is the phase when the ‘Law of
constant returns’ is in operation.
• From 7 to 11 workers, though the T.P. is increasing, the M.P. goes on decreasing. This is the phase of
‘Diminishing Returns’.

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Diagrammatic illustration of the law of diminishing returns

The following figure is a diagrammatic presentation of the Law of returns roughly representing the figures in
the table given before

H
Y

Stage II

Stage I T.P. Curve

Stage III

A.P. Curve

M M.P. Curve X

In the above figure the T.P. curve goes on increasing to a point and after than it starts declining. A.P. and
M.P. curves also rise and then decline. M.P. curve starts declining earlier than the A.P. curve. The behavior
of the output when the varying quantity of one factor is combined with a fixed quantity of other can be
divided into three distinct stages.

Stage I:

In this stage T.P. to a point increases at an increasing rate. In the figure from the origin to the point F, slope
of the total product curve T.P. is increasing i.e. up to the point F, i.e. T.P. increases at an increasing rate,
which means that M.P. rises. From the point F onwards during the Stage I, the T.P. curve goes on rising but
its slope is declining which means that from point F onwards the T.P. increases at a diminishing rate i.e.
M.P. falls but it is positive. The point F where the total product stops at an increasing rate and starts
increasing at a diminishing rate is called the ‘point of inflexion’. Corresponding vertically to this point of
inflexion, M.P. is maximum, after which it slopes downward. The stage I ends where the AP curve reaches
its highest point S. Stage I is known as the stage of ‘increasing returns’ because A.P. of the variable factor
increases throughout this stage.

Stage II:

In stage II, the T.P. continues to increase at a diminishing rate until it reaches its maximum point H where
the second stage ends. In this stage both the M.P. and A.P. of the variable factor is zero, when T.P. is
highest as shown by point H. Stage II is important because the firm will seek to produce in its range. This
stage is known as the stage of diminishing returns as both the A.P. and M.P. continuously fall during this
stage.

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Stage III:

In stage III, T.P. declines and therefore T.P. curve slopes downward. As a result M.P. of the variable factor
in negative and the M.P. curve goes below the X-axis. This stage is called the stage of negative returns,
since the M.P. of the variable factor is negative during this stage.

Explanation of the various stages

1. Increasing returns: In the beginning, the quantity of fixed factor is abundant relative to the
quantity of the variable factor. As more and more units of variable factors are added to constant quantity of
fixed factor then fixed factor gets more intensively and effectively utilized and production increases at a
rapid rate.

In the given example, throughout the three stages fixed variable i.e. machinery remains constant. The
variable factor i.e. no. of workers increase as a firm expands its production. A worker contributes 5 units per
day to the firm’s output. The total product reaches 50 units per day when the 4 th worker contributes to the
production. Fuller utilization of capital is possible due to the addition of a variable factor. When the fourth
worker joins it is possible to use the full potential of the capital.

2. Diminishing Returns: The peculiar feature of this stage is that the marginal product falls
through out the stage and finally touches to zero. Corresponding vertically is the point h, which is the
highest point of the TP curve. Here the stage II ends.

In the table given, the third stage is set in by hiring 7th worker who adds only 15 units per day as compared
to 20 units per day added by the 6th worker. Total Product increases but gain from 7th worker is not as great
as gain from the 6th worker. Explanation to this can be given as once the point is reached at which variable
factor is sufficient to ensure full utilization of fixed factor, then further increase in variable factor will cause
MP as well as AP to fall because fixed factor has now become inadequate relative to the quantity of variable
factors. In stage II fixed factor is scarce as compared to variable factor.

3. Negative returns: In this stage, marginal product falls below X-axis i.e. negative because
total product starts falling. In our example this is set in by hiring 13th worker. The total product falls from
127 units to 118 units. The large number of variable factors impairs the efficiency of the fixed factor. The
excessive variable factor as compared to less fixed factor results in a fall of total output. In such a situation,
a reduction in the units of the variable factor will increase the total output.