Chapter 1

INTRODUCTION TO MANAGERIAL ECONOMICS

Important definitions of economics

The word economics originates from the Greek words ‘oikos’ and ‘nomos’ which mean
household and management respectively. Economics deals with solving economic problems
and making decisions such as what to produce, how to produce and for whom to produce.
These economic problems give rise to the problem of choice, which arises because there are
unlimited resources and limited resources with alternative uses.

 Prof. Adam Smith defined economics as a study of production, exchange and

consumption of wealth.
 Prof. Alfred Marshal defined economics as the study of mankind in the ordinary
business of life.
 Prof Lionel Robbins defined economics as a social science which deals with optimum
allocation of scarce resources with alternative uses.

Prof. Ragnar Frisch has classified economics in to Microeconomics and Macroeconomics.

 Microeconomics: it deals with the behaviour of individual economics units such as

individuals, firms, buyers, sellers and so on. Therefore it is called the worm’s eye
view of the economy
 Macroeconomics: deals with aggregates of the economy at large such as national
income, general price index, total employment and unemployment, wage rate,
money supply, savings and so on. Therefore it is called the bird’s eye view of the
economy.

Kinds of economic decisions

 Production decisions: since the resources are limited producers should decide what
to produce (commercial goods or social goods) ; how to produce( to use capital
intensive or labour intensive techniques) and how much to produce( quantities
based on price, inputs, demand etc.)
 Exchange decisions: who is the target group of buyers for each product (whole sale
or retail, domestic or international) and at what prices?
 Consumption decisions: what to buy (based on taste and preferences) and how
much to buy (based on income, price, price of relative goods etc.)
Meaning of Managerial economics

Management decisions need to be made in any organisation be it a firm, a not for profit
organization or a government agency- when it seeks to achieve some goals or objectives
subject to constraints (limitations).

Managerial Economics refers to the study that integrates economic theory , decision
sciences ,and the functional areas of business administration studies; and it examines how
they interact with one another as the firm attempts to achieve its goals most effectively.

*economic theory refers to microeconomics and macroeconomics.

In other words managerial economics can broadly be defined as the study of economic
theories, logic and tools of economic analysis that are used in the process of business
decision making. Economic theories and techniques of economic analysis are applied to
analyse business problems, evaluate business options and opportunities with a view to
arriving at an appropriate business decision.

Significance of Managerial economics

Business managers have to achieve the firms objectives with limited resources i.e. finance,
men or material. Therefore they have to make decisions regarding using these limited
resources in the most efficient and economic way. Therefore it is important for managers to
be well equipped with economic theories and tools.

In today’s complex business environment, decision making process has become complex as
well as the businesses need to consider multiple factors such as changing consumer
behaviour, market forces , high competition, international competition, new trends,
technology, government policy, input prices and so on. These factors increase the
unpredictability of the decisions made hence increases the risk. Economic theories, models
and econometric tools and techniques helps the managers reduce the risk and increases
predictability thus helping them make better decisions.

Application of Managerial economics

Economic theories state the functional relationship between two or more economic
variables, under certain given conditions. Application of relevant economic theories the
problems of business facilitates decision making in at least three ways.

 It gives a clear understanding of various economic concepts used in business

analysis. For example, the concept of cost includes total cost, variable cost,
actual and opportunity cost. Economics clarifies concepts that are relevant to
understanding business information.
  It helps in ascertaining the relevant variables and specifying the relevant data.
For example the factors influencing demand for a particular product
 Economic theories state the general relationship between two or more economic
variables and events. Application of the relevant economic theory provides
consistency to business analysis and helps in arriving at right conclusions.
Thus, application of economic theories to the problems of business not only
guides, assists and streamlines the process of decision making but also
contributes a good deal to the validity of decisions.

Scope of Managerial Economics

In general managerial economics is economics applied to the analysis of business problems

and decision making, which can be termed as applied economics which can be broadly
divided in to

I. Microeconomics applied to operational or internal issues

The issues mainly dealt under this include all operational issues are which arise
within the business organization like choice of product, technology, pricing, promotion,
investments, inventory etc. The following micro economic theories deal with most of these
questions

 Demand theory: deals with the consumer behaviour, hence helps the
organisation in deciding on type of commodities to be produced, quantity
and price
 Theory of production and production decisions: helps in determining the size
of the firm, size of the output and the amount of capital and labour to be
employed.
 Analysis of market structure and pricing theory: explains how price is
determined under different market conditions.
 Profit analysis and profit management: this theory guides firms in the
measurement and management of profit, in making allowances for the risk
premium in calculating the return on capital and profit thus allowing for
future planning.
 Theory of capital and investment decisions: contributes to the investment
decision making, choice of project, maintaining the capital, capital budgeting,
etc.
II. Macroeconomics applied to business environment
This includes environmental issues pertaining to general business environment i.e.
economics, social and political atmosphere of the country. The following issues are
dealt under this-
  The type of economic system in the country
 General trends in national income, employment, prices, saving and
investment, etc.
 Structure of and trends in the working of financial institutions such as banks,
financial corporations, insurance companies, etc.
 Magnitude of and trends in foreign trade
 Trends in labour supply and strength of the capital market,
 Government policies such as industrial policy, monetary policy, fiscal policy
etc.
 Social factors like value system of the society, property rights, customs and
habits.
 Political environment and system – democratic, authoritarian or socialist
which determines the state’s attitude towards private business, size and
working of the public sector and stability.
 Degree of globalization of the economy and the influence of MNCs on the
domestic markets.

Theory of Firm

In this theory we discuss the reasons for the existence of the firm, their principal functions,
value of the firm and constraints under which firm operates.

Reasons for the existence of the firm and their functions

A firm is an organisation that combines and organizes resources for the purposes of
producing goods or services for sale. Firm is a broad term which includes proprietorships,
partnerships and corporations.

Firms exist because it would be very inefficient and costly for entrepreneurs to enter into
and enforce contracts with and owners of capital, land and other resources for each spate
step of production and distribution process. Therefore entrepreneurs enter in to long term
and broad contracts with labour to perform a number of tasks. The firm exists in order to
save on transaction costs. Firm internalises many transaction under its name thus saving on
time, taxes, regulations and so on.

As the firms grow larger and larger, more functions get included it becomes complex to
manage economies of scale in terms of cost and time. At this level firms start decentralizing
the functions and management gets distant from operations of sub divisions. Further firms
experience increasing costs to supply additional functions thus start outsourcing these
functions to other firms.
Firm is the central to the flow of factors of production i.e. land, labour, capital and
organisation and factor rewards i.e. rent, wages, interest and profit in the economy. Firms
purchase the factors of production from households and give factor rewards for the same.
Firms manufacture goods and services using these factors of production and distribute them
to the households who spend their income on purchasing these goods and services. Thus
completing the circular flow of income in the economy. In this process, firms create jobs and
pay taxes to government which is used to run the governance machinery i.e. defence,
education, social services etc.

The Objective and value of the firm

Generally assumed that profit is the main objective of the firm, in other words the theory of
the firm was based on the assumption that the goal or objective of the firm was to maximize
current or short term profits. However in reality firms usually sacrifice short term profits for
the sake of long term profits.

According to theory of firm, even though both short term and long term profits are
important, a firms primary objective is to maximize the wealth or value of the firm.( the firm
has to sacrifice short term profits i.e. by spending on promotional activities, capital
investment, machinery, research and development, etc.)

The value of the firm can be calculated by taking into consideration present value of all
expected future profits of the firm. Future profits of the firm must be discounted to the
present because a Rupee of profit in the future is worth less than a dollar of profit today.

The value or the wealth of the firm can be calculated by:

PV= π1 + π2 + π3 + …..+ πn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

=∑

Where,

PV= Present value

π1, π2,……., πn, = represent the expected profits in each year

n= years considered

r= appropriate discount rate to find the present value of the profits

∑= sum of

Since profits are equal to the total revenue (TR) minus total costs (TC), the equation
can rewritten as

Value of the firm = ∑

As profit or π = TR-TC

 TR depends on sales or the demand for the firm’s output and the firm’s pricing
decisions.
 TC depends on the technology of production and input prices.
 ‘r’ or the discount rate depends on the perceived risk of the firm and cost of
borrowing of funds.

However, the firm can reduce its risk by improving its technology, information, quality,
better accounting and costing strategies, etc.

Constraints on the operation of the firm

The firm’s main objective is to maximize wealth or value of the firm but to achieve this goal
the firm’s face many constraints such as

 Procuring suitable inputs like raw materials, technology etc.

 Acquiring skilled labour or workforce
 Storage facilities or warehousing facilities
 Capital requirements
 Legal constraints, environmental restrictions etc.

Therefore every firm aims at constrained optimization i.e. the firm tries to maximize its
wealth or value subject to the constraints it faces as existence of these constraints restricts
the range of freedom of action of the firm and limits the value of the firm when compared
to its value without constraints.

Limitations of the theory of the firm

The theory of the firm has been criticized for being too narrow and unrealistic as it does not
give importance to the other equally important objectives of the firm such as maximization
of sales, maximization of management utility and satisficing behaviour.
Although many alternative theories have been proposed, there is suitable replacement or
alternative for the theory of the firm as it relatively accurate in explaining the behaviour of
the firms.

Economic Principles relevant to managerial decision making

Managerial economics is concerned with decision making at the level of the firm. Decisions
have far reaching effects on the firm and are often not easy to make, therefore it is
recommended that he systematic efforts are made to arrive at right decisions.

The Basic Process of Decision Making

The decision making process involves the following six broad steps according to Peter
Drucker.

1. Define the problem

2. Determine the objective
3. Identify possible solutions
4. Select the best possible solution
5. Implement the decision
6. Monitor the performance

Before going on details on individual problems of decision making it is important to

understand the basic principles of managerial economics.

Basic Principles
Business are involved in a process of constant decision making in order to achieve pre-
determined goals and to make these decisions some fundamental economic concepts are
used explicitly or implicitly, deliberately or otherwise. The following are the most important
economic principles are used in making business decisions.

Opportunity Cost Principle

This principle deals with the concept of scarcity. Scarcity arises because humans have
unlimited wants and limited resources with alternative resources are available to satisfy
these wants.

The resources available to a business unit i.e. an individual firm, Joint Stock Company or a
multinational company is limited, therefore the firms have to decide on how to use these
limited resources in order to achieve its objectives.

For example, suppose a firm has Rs. 10 crore at its disposal and the firma finds three risk-
free alternative uses of the fund available to it:
  Alternative 1: expansion of the size of the firm can earn revenue of Rs. 2 crore
 Alternative 2: setting up a new production unit in another city can earn Rs.1.8 crore
 Alternative 3: Buying shares in another firm can earn revenue of Rs.1.6 crore

All other things being same, a rational decision for the firm would be to invest the money in
alternative 1, thus the manger would have to sacrifice the annual return of the second best
alternative i.e., a return of Rs. 1.8 crore. Therefore in this case we call Rs. 1.8 crore sacrificed
or foregone as the annual opportunity cost of Rs 2 crore. Thus, the opportunity cost of
availing an opportunity is foregone income expected from second best opportunity of using
the resources.

Therefore Economic gain or Economic profit = Actual earning – opportunity cost. (The
economic gains should not be too small or too big as it may hamper decision making
process)

Case study:

A firm has to take a decision on whether to fire an efficient labour officer for treating labour
unkindly in settlement of a dispute with the labour union or to allow the matter to be taken
to the labour court.

In this case there are two possible outcomes

 If the firm decides to fire the labour officer, then it losses an efficient and reliable
labour officer , here the opportunity cost of buying peace with the labour union is
losing a good resource and hiring cost of another labour officer
 If the firm decides to retain the officer, then the firm may have to incur costs of
prolonged litigation, cost of arising out of prolonged labour strike and the
consequent reduction in output are the opportunity costs of retaining the labour
officer.

Which is the suitable option for the firm to decide upon after evaluating the cost and
benefit of each option? Why?

Marginal Principle and Decision rule

Marginal concept is widely used in economics. The term marginal means change in total
quantity due to on unit change in its determinant. It can be explained using the concept of
cost and revenue of a firm.

Example: if a firm is producing 100 units of chocolates and its total cost is Rs. 2500 and the
total cost for producing 101 units is Rs. 2550. Then the

MC = TCn-TCn-1

MC is Marginal cost, TCn is total cost of n units and TCn-1 is total cost of n-1 units
MC101= TC101 –TC100

MC101= 2550- 2500

= 50

Which means to produce the 101th unit the firm will incur a cost of Rs.50

Example 2: a firm has a selling price of Rs. 30 per unit of chocolate for an order of 100 units
and Rs. 28 per unit if the order ranges between 100-150 units.

TR= P×Q

Where TR is total revenue, P is Price and Q is quantity sold.

Here TR100= 30×100

= 3000

And if firm sells 101 units then the total revenue is

TR101= 30×100+28×1

=3000+28

=3028

Therefore MR = TRn-TRn-1

Where MR is Marginal revenue, TRn is total revenue for n units and TRn-1 is total revenue for
n-1 units.

MR101=TR101-TR100

= 3028- 3000

= 28

Now that we have understood the marginal concept, we need to understand how firm
decide upon how much to produce so that profit is maximum. The decision rule that firms
use is that

 MR>MC suggests that the production can be carried on if MR is more than MC as the
firm is earning profit
 MR=MC, in this case the firm will be producing profit maximizing output.
Incremental Principle and decision Rule

The concept of incremental principle is similar to the concept of marginal principle.

Marginal principle is related to individual units, and for companies which sell products in
bulk marginal principle for decision making is not so relevant. Therefore Incremental
principle is applied to business decisions which involve bulk production and a large
increase in total cost and total revenue.

Incremental costs can be defined as the costs that arise due to a business decision, in
other words when the total cost of production increases due to a business decision is
called as incremental cost. For example when the firm’s cost of production increases
from 10 crore to 12 crore due to increase in labour cost, then the

Incremental cost= 12 crore- 10 crore= 2 crore

Incremental cost includes, explicit costs ( fixed cost + variable cost), opportunity
cost(expected income foregone form the second best alternative involved in the
business decision) and future costs( like depreciation, legal expenses, taxes, advertising
and others)

Incremental revenue is the increase in revenue due to a business decision such as

increase in sales and increase in production of the firm. When a business decision is
successfully implemented, it does result in a significant increase in its total revenue and
the excess revenue obtained is incremental revenue. For example : after installation of a
new plant, the total production increases and the firm is able to sell the incremental
product, the total sales revenue increases from 12 crore to 15 crore.

Therefore the incremental revenue = 15 crore- 12 crore= 3 crore.

The use of incremental concept in business decisions is called incremental reasoning,

which is used in accepting or rejecting a business proposition or option, based on the
incremental revenue received from each business decision. For example in the above
case

The incremental cost< incremental revenue i.e. 2 crores< 3 crores. Therefore there is a
net benefit in 3 crores- 2 crores= 1 crores. The incremental revenue exceeds the
incremental cost by 33.33% i.e. 1 crore. The firm will accept the proposition provided
that there is no better business proposition available to the firm.
 Production possibility curve

A PPF (production possibility frontier) typically takes

the form of the curve illustrated on the right. A
production process that is operating on the PPF is
said to be efficient, meaning that it would be
impossible to produce more of one good without
decreasing production of the other good. In contrast,
if the production process is operating below the
curve, it is said to be operating inefficiently because
it could reallocate resources in order to produce
more of both goods or some resources such as labor
or capital are sitting idle and could be fully employed
to produce more of both goods

Here we can see that the firm has the resources enough
to produce maximum of 100 tons of butter or 100 cases
of guns. But the opportunity cost for the butter and guns
differ i.e. initially we ca see that in to produce 10 tins
extra butter only 5 cases of guns have to be given up
(shift from A to B) but in the shift from C to D we can that
the opportunity cost increases as to increase only 10 tons
of butter the firm has to sacrifice 50 cases of guns.

Therefore the concept of PPF(production possibility front

or curve ) is used by firms to make decisions regarding
the optimum quantities to produce considering the
opportunity cost for the products considered.

Discounting Principle and decision process

Purchasing power of money or the value of money diminishes with time due to changing
price or inflation, uncertainty, monetary policy, foreign exchange prices etc. in other words,
a rupee today is worth more than a rupee in a future date. Therefore firms use the
discounting principle as a decision making yardstick to ascertain the future returns in
present value of money.

This principle is based on a simple arithmetic concept.

Illustration: suppose an investment costs RS100 lakhs this year and is expected to yield net
returns of Rs. 30 lakhs, Rs 40 lakhs and 60 lakhs, in the next three years, respectively.
Assume that the interest cost of the money is 10 %, there is no inflation/ deflation and no
 uncertainty about these cash flows. Then, whether the investment should be made or not
depends upon whether the following equation yields a positive or a negative value:

The solution to this yields an amount of Rs. 27.1614 lakhs, and so the investment is
desirable.

Important Questions and previous year Questions

5 marks.
1. Define opportunity cost. Explain its importance in managerial economics.
(2012)
2. Explain consumer equilibrium under cardinal utility analysis. (2012, and 2014)
3. What is the use of incremental analysis in business decision making.(2010)
4. Define Managerial Economics. Explain its scope.(2013)
5. Distinguish between incremental and marginal analysis.
6. Briefly explain the objectives of the firm.(2016)
7. Give the significance of Marginal concept in Decision making.(2016)
8. Explain the concept of Production possibility curve by linking it to opportunity
cost.(2015)
9. Compare the contrast of microeconomics with macroeconomics(2007)
10. Critically examine profit maximization vs sales maximization(2014)