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Introduction:

Managerial Economics is both conceptual and metrical. Before


the substantive decision problems which fall within the purview
of managerial economics are discussed, it is useful to identify
and understand some of the basic concepts underlying the
subject.
Economic theory provides a number of concepts and analytical
tools which can be of considerable and immense help to a
manager in taking many decisions and business planning. This
is not to say that economics has all the solutions. In fact, actual
problem solving in business has found that there exists a wide
disparity between economic theory of the firm and actual
observed practice.
Therefore, it would be useful to examine the basic tools of
managerial economics and the nature and extent of gap
between the economic theory of the firm and the managerial
theory of the firm. The contribution of economics to managerial
economics lies in certain principles which are basic to
managerial economics. There are six basic principles of
managerial economics. They are:
Content:
1. The Incremental Concept
2. The Concept of Time Perspective
3. The Opportunity Cost Concept
4. The Discounting Concept
5. The Equi-marginal Concept

6. Risk and Uncertainty

1. The Incremental Concept:


The incremental concept is probably the most important
concept in economics and is certainly the most frequently used
in Managerial Economics. Incremental concept is closely
related to the marginal cost and marginal revenues of
economic theory.
The two major concepts in this analysis are incremental cost
and incremental revenue. Incremental cost denotes change in
total cost, whereas incremental revenue means change in total
revenue resulting from a decision of the firm.
The incremental principle may be stated as follows:
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases
others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
Illustration:
Some businessmen hold the view that to make an overall
profit, they must make a profit on every job. The result is that
they refuse orders that do not cover full costs plus a provision
of profit. This will lead to rejection of an order which prevents

short run profit. A simple problem will illustrate this point.


Suppose a new order is estimated to bring in an additional
revenue of Rs. 10,000. The costs are estimated as under:
Labour Rs. 3,000
Materials Rs. 4,000
Overhead charges Rs. 3,600
Selling and administrative expenses Rs. 1,400
Full Cost Rs.12, 000
The order appears to be unprofitable. For it results in a loss of
Rs. 2,000. However, suppose there is idle capacity which can
be utilised to execute this order. If order adds only Rs. 1,000 to
overhead charges, and Rs. 2000 by way of labour cost because
some of the idle workers already on the pay roll will be
deployed without added pay and no extra selling and
administrative costs, then the actual incremental cost is as
follows:
Labour Rs. 2,000
Materials Rs. 4,000
Overhead charges Rs. 1,000
Total Incremental Cost Rs. 7,000
Thus there is a profit of Rs. 3,000. The order can be accepted
on the basis of incremental reasoning. Incremental reasoning
does not mean that the firm should accept all orders at prices
which cover merely their incremental costs.

The concept is mainly used by the progressive concerns. Even


though it is a widely followed concept, it has certain
limitations:
(a) The concept cannot be generalised because observed
behaviour of the firm is always variable.
(b) The concept can be applied only when there is excess
capacity in the concern.
(c) The concept is applicable only during the short period.

2. Concept of Time Perspective:

The time perspective concept states that the decision maker


must give due consideration both to the short run and long run
effects of his decisions. He must give due emphasis to the
various time periods. It was Marshall who introduced time
element in economic theory.
The economic concepts of the long run and the short run have
become part of everyday language. Managerial economists are
also concerned with the short run and long run effects of
decisions on revenues as well as costs. The main problem in
decision making is to establish the right balance between long
run and short run.
In the short period, the firm can change its output without
changing its size. In the long period, the firm can change its
output by changing its size. In the short period, the output of
the industry is fixed because the firms cannot change their size
of operation and they can vary only variable factors. In the

long period, the output of the industry is likely to be more


because the firms have enough time to increase their sizes and
also use both variable and fixed factors.
In the short period, the average cost of a firm may be either
more or less than its average revenue. In the long period, the
average cost of the firm will be equal to its average revenue. A
decision may be made on the basis of short run considerations,
but may as time elapses have long run repercussions which
make it more or less profitable than it at first appeared.
Illustration:
The firm which ignores the short run and long run
considerations will meet with failure can be explained with the
help of the following illustration. Suppose, a firm having a
temporary idle capacity, received an order for 10,000 units of
its product. The customer is willing to pay only Rs. 4.00 per
unit or Rs. 40,000 for the whole lot but no more.
The short run incremental cost (ignoring the fixed cost) is only
Rs. 3.00. Therefore, the contribution to overhead and profit is
Rs. 1.00 per unit (or Rs. 10, 000 for the lot). If the firm
executes this order, it will have to face the following
repercussion in the long run:
(a) It may not be able to take up business with higher
contributions in the long run.
(b) The other customers may also demand a similar low price.
(c) The image of the firm may be spoilt in the business
community.

(d) The long run effects of pricing below full cost may be more
than offset any short run gain.
Haynes, Mote and Paul refer to the example of a printing
company which never quotes prices below full cost due to the
following reasons:
(1) The management realized that the long run repercussions
of pricing below full cost would more than offset any short run
gain.
(2) Reduction in rates for some customers will bring
undesirable effect on customer goodwill. Therefore, the
managerial economist should take into account both the short
run and long run effects as revenues and costs, giving
appropriate weight to most relevant time periods.

3. The Opportunity Cost Concept:


Both micro and macro economics make abundant use of the
fundamental concept of opportunity cost. In everyday life, we
apply the notion of opportunity cost even if we are unable to
articulate its significance. In Managerial Economics, the
opportunity cost concept is useful in decision involving a choice
between different alternative courses of action.
Resources are scarce, we cannot produce all the commodities.
For the production of one commodity, we have to forego the
production of another commodity. We cannot have everything
we want. We are, therefore, forced to make a choice.
Opportunity cost of a decision is the sacrifice of alternatives
required by that decision. Sacrifice of alternatives is involved

when carrying out a decision requires using a resource that is


limited in supply with the firm. Opportunity cost, therefore,
represents the benefits or revenue forgone by pursuing one
course of action rather than another.
The concept of opportunity cost implies three things:
1. The calculation of opportunity cost involves the
measurement of sacrifices.
2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed
alternatives.
Opportunity cost is just a notional idea which does not appear
in the books of account of the company. If resource has no
alternative use, then its opportunity cost is nil.
In managerial decision making, the concept of opportunity cost
occupies an important place. The economic significance of
opportunity cost is as follows:
1. It helps in determining relative prices of different goods.
2. It helps in determining normal remuneration to a factor of
production.
3. It helps in proper allocation of factor resources.

4. Equi-Marginal Concept:
One of the widest known principles of economics is the equimarginal principle. The principle states that an input should be

allocated so that value added by the last unit is the same in all
cases. This generalisation is popularly called the equi-marginal.
Let us assume a case in which the firm has 100 unit of labour
at its disposal. And the firm is involved in five activities viz., ,
, C, D and E. The firm can increase any one of these activities
by employing more labour but only at the cost i.e., sacrifice of
other activities.
An optimum allocation cannot be achieved if the value of the
marginal product is greater in one activity than in another. It
would be, therefore, profitable to shift labour from low marginal
value activity to high marginal value activity, thus increasing
the total value of all products taken together.
If, for example, the value of the marginal product of labour in
activity A is Rs. 50 while that in activity is Rs. 70 then it is
possible and profitable to shift labour from activity A to activity
B. The optimum is reached when the values of the marginal
product is equal to all activities. This can be expressed
symbolically as follows:
VMPLA = VMPLB = VMPLC = VMPLD = VMPLE
Where VMP = Value of Marginal Product.
L = Labour
ABCDE = Activities i.e., the value of the marginal product of
labour employed in A is equal to the value of the marginal
product of the labour employed in and so on. The
equimarginal principle is an extremely practical notion.

It is behind any rational budgetary procedure. The principle is


also applied in investment decisions and allocation of research
expenditures. For a consumer, this concept implies that money
may be allocated over various commodities such that marginal
utility derived from the use of each commodity is the same.
Similarly, for a producer this concept implies that resources be
allocated in such a manner that the marginal product of the
inputs is the same in all uses.

5. Discounting Concept:
This concept is an extension of the concept of time
perspective. Since future is unknown and incalculable, there is
lot of risk and uncertainty in future. Everyone knows that a
rupee today is worth more than a rupee will be two years from
now. This appears similar to the saying that a bird in hand is
more worth than two in the bush. This judgment is made not
on account of the uncertainty surrounding the future or the risk
of inflation.
It is simply that in the intervening period a sum of money can
earn a return which is ruled out if the same sum is available
only at the end of the period. In technical parlance, it is said
that the present value of one rupee available at the end of two
years is the present value of one rupee available today. The
mathematical technique for adjusting for the time value of
money and computing present value is called discounting.
The following example would make this point clear. Suppose,
you are offered a choice of Rs. 1,000 today or Rs. 1,000 next
year. Naturally, you will select Rs. 1,000 today. That is true

because future is uncertain. Let us assume you can earn 10 per


cent interest during a year.
You may say that I would be indifferent between Rs. 1,000
today and Rs. 1,100 next year i.e., Rs. 1,100 has the present
worth of Rs. 1,000. Therefore, for making a decision in regard
to any investment which will yield a return over a period of
time, it is advisable to find out its net present worth. Unless
these returns are discounted and the present value of returns
calculated, it is not possible to judge whether or not the cost of
undertaking the investment today is worth.
The concept of discounting is found most useful in managerial
economics in decision problems pertaining to investment
planning or capital budgeting.
The formula of computing the present value is given below:
V = A/1+i
where:
V = Present value
A = Amount invested Rs. 100
i = Rate of interest 5 per cent
V = 100/1+.05 = 100/1.05 =Rs. 95.24
Similarly, the present value of Rs. 100 which will be discounted
at the end of 2 years: A 2 years V = A/ (1+i) 2
For n years V = A/ (1+i) n

6. Risk and Uncertainty:

Managerial decisions are actions of today which bear fruits in


future which is unforeseen. Future is uncertain and involves
risk. The uncertainty is due to unpredictable changes in the
business cycle, structure of the economy and government
policies.
This means that the management must assume the risk of
making decisions for their institution in uncertain and unknown
economic conditions in the future. Firms may be uncertain
about production, market prices, strategies of rivals, etc. Under
uncertainty, the consequences of an action are not known
immediately for certain.
Economic theory generally assumes that the firm has perfect
knowledge of its costs and demand relationships and of its
environment. Uncertainty is not allowed to affect the decisions.
Uncertainty arises because producers simply cannot foresee
the dynamic changes in the economy and hence, cost and
revenue data of their firms with reasonable accuracy.
Also dynamic changes are external to the firm, they are
beyond the control of the firm. The result is that the risks from
unexpected changes in a firms cost and revenue data cannot
be estimated and therefore the risks from such changes cannot
be insured. But products must attempt to predict the future
cost and revenue data of their firms and determine the output
and price policies.
The managerial economists have tried to take account of
uncertainty with the help of subjective probability. The
probabilistic treatment of uncertainty requires formulation of

definite subjective expectations about cost, revenue and the


environment. The probabilities of future events are influenced
by the time horizon, the risk attitude and the rate of change of
the environment.