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EAB - Unit I Notes

What is 'Economics?'

Economics is a social science concerned with the production, distribution and consumption of
goods and services. It studies how individuals, businesses, Governments and nations make
choices on allocating resources to satisfy their wants and needs, and tries to determine how
these groups should organize and coordinate efforts to achieve maximum output.

Economic analysis often progresses through deductive processes, much like mathematical
logic, where the implications of specific human activities are considered in a "means-ends"
framework.

Economics can generally be broken down into macroeconomics, which concentrates on the
behavior of the aggregate economy, and microeconomics, which focuses on individual
consumers.

Managerial Economics - Definition

Spencer and Siegelman have defined the subject as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”

Difference between Micro and Macro Economics

Nature of Managerial Economics

Traditional economic theory has developed along two lines; viz., normative and positive.
Normative focuses on prescriptive statements, and help establish rules aimed at attaining the
specified goals of business. Positive, on the other hand, focuses on description it aims at
describing the manner in which the economic system operates without staffing how they
should operate. The emphasis in business economics is on normative theory. Business
economic seeks to establish rules which help business firms attain their goals, which indeed

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

is also the essence of the word normative. However, if the firms are to establish valid
decision rules, they must thoroughly understand their environment. This requires the study of
positive or descriptive theory. Thus, Business economics combines the essentials of the
normative and positive economic theory, the emphasis being more on the former than the
latter.

Scope of Managerial Economics

As regards the scope of business economics, no uniformity of views exists among various
authors. However, the following aspects are said to generally fall under business economics.
1. Demand Analysis and Forecasting
2. Cost and production Analysis.
3. Pricing Decisions, policies and practices.
4. Profit Management.
5. Capital Management.

These various aspects are also considered to comprise the subject matter of business
economic.

1. Demand Analysis and Forecasting: A business firm is an economic organisation which


transforms productive resources into goods to be sold in the market. A major part of business
decision making depends on accurate estimates of demand. A demand forecast can serve as a
guide to management for maintaining and strengthening market position and enlarging
profits. Demands analysis helps identify the various factors influencing the product demand
and thus provides guidelines for manipulating demand. Demand analysis and forecasting
provided the essential basis for business planning and occupies a strategic place in
managerial economic. The main topics covered are: Demand Determinants, Demand
Distinctions and Demand Forecast.

2. Cost and Production Analysis: A study of economic costs, combined with the data drawn
from the firm‟s accounting records, can yield significant cost estimates which are useful for
management decisions. An element of cost uncertainty exists because all the factors
determining costs are not known and controllable. Discovering economic costs and the ability
to measure them are the necessary steps for more effective profit planning, cost control and
sound pricing practices. Production analysis is narrower, in scope than cost analysis.
Production analysis frequently proceeds in physical terms while cost analysis proceeds in
monetary terms. The main topics covered under cost and production analysis are: Cost
concepts and classification, Cost-output Relationships, Economics and Diseconomics of
scale, Production function and Cost control.

3. Pricing Decisions, Policies and Practices: Pricing is an important area of business


economic. In fact, price is the genesis of a firm‟s revenue and as such its success largely
depends on how correctly the pricing decisions are taken. The important aspects dealt with
under pricing include. Price Determination in Various Market Forms, Pricing Method,
Differential Pricing, Product-line Pricing and Price Forecasting.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

4. Profit Management: Business firms are generally organised for purpose of making profits
and in the long run profits earned are taken as an important measure of the firm‟s success. If
knowledge about the future were perfect, profit analysis would have been a very easy task.
However, in a world of uncertainty, expectations are not always realised so that profit
planning and measurement constitute a difficult area of business economic. The important
aspects covered under this area are: Nature and Measurement of profit, Profit policies and
Technique of Profit Planning like Break-Even Analysis.

5. Capital Management: Among the various types business problems, the most complex and
troublesome for the business manager are those relating to a firm‟s capital investments.
Relatively large sums are involved and the problems are so complex that their solution
requires considerable time and labour. Often the decision involving capital management is
taken by the top management. Briefly Capital management implies planning and control of
capital expenditure. The main topics dealt with are: Cost of capital Rate of Return and
Selection of Projects.

Profit Maximization Model of a Firm

 The efficient management of a business firm requires an optimal or best solution out
of the available courses of action for a firm.
 This efficient or optimal decision making requires establishing the goal or objective to
be achieved.
 Whether a management decision is optimal or not can be evaluated against the goal or
objective that the firm seeks to achieve.
In traditional economic model of the firm it is assumed that a firm‟s objective is to maximise
short-run profits, that is, profits in the current period which is generally taken to be a year. In
various forms of market structure such as perfect competition, monopoly, monopolistic
competition the traditional microeconomic theory explains the determination of price and
output by assuming that firm‟s aim is to maximise current or short-run profits. This current
short-run profit maximisation model of the firm has provided decision makers with useful
framework with regard to efficient management and allocation of resources.

Profit is a difference between total revenue and total cost. It may be noted that the concept of
cost used in economic theory and managerial economics is different from the concept of
accounting cost used by accountants. This difference in the concepts of costs makes the
concept of profits used in economic theory different from that used in its calculation by the
accountant. It is to state here that economic profits are the difference between total revenue
and economic costs. Thus,

=TR-TC
Where stands for total economic profits, TR for total revenue and TC for total economic
costs. It is economic profits which firms try to maximise in their decision making about level

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

of output to be produced and price to be charged for its product. TR curve represents total
revenue earned from selling varying amounts of output of a product. TC curve depicts total
economic costs at different levels of output. It will be seen from the upper part at OM level of
output, total revenue equals total economic costs and therefore at this level of output the firm
is just breaking even.
Therefore, point B at which TR curve cuts TC curve is called break-even point. Beyond this
break-even level of output positive profits start accruing to the firm as it expands its level of
output. Profits go on increasing till output level OQ is reached.

Profit Maximization Model of a Firm – Traditional Approach (π = TR-TC)

It can be seen from the upper part of that profits start declining as output is expanded beyond
OQ. Therefore, a firm which aims to maximise profits will produce output level of OQ, and
will charge a price of its product which buyers are prepared to pay depending on the demand
conditions.
Since price or average revenue equals total revenue divided by a level of output, price
charged by the firm at output level OQ is given TR/OQ or QJ/OQ
The simple profit-maximizing model of the firm provides very useful guidelines for the
decision making by the firm with regard to efficient resource management.

Thus, any business decision by a firm will increase its profits if the following conditions
prevail:
1. It brings about increase in total revenue more than increase in costs.
2. It causes increase in revenue, costs remaining unchanged.
3. It reduces cost more than it reduces revenue.
4. It reduces costs, revenue remaining the same.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

Limitations:
Despite the merits of the profit maximising model of the firm, it has two important
limitations. First, it does not incorporate time dimension in the decision-making process by
the firm. Secondly, it does not analyse the firm‟s behaviour under conditions of risk and
uncertainty. The modern model of the firm known as „Firm‟s value Maximization Model „or
Shareholder‟s wealth Maximising Model‟ overcomes these limitations by incorporating time
dimension into the managerial decision-making process. This model also considers risk
involved in business decision-making.

Modern Approach

Under perfect competition, the firm is one among a large number of producers. It
cannot influence the market price of the product. It is the price-taker and quantity-adjuster. It
can only decide about the output to be sold at the market price. Therefore, under conditions of
perfect competition, the MR curve of a firm coincides with its AR curve. The MR curve is
horizontal to the X-axis because the price is set by the market and the firm sells its output at
that price. The firm is, thus, in equilibrium when MC = MR (Price). The equilibrium of the
profit maximisation firm under perfect competition is. It satisfies the condition of MC = MR,

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

but it is not a point of maximum profits because after point A, the MC curve is below the MR
curve.

Criticism of the Profit Maximisation Theory:

The profit maximisation theory has been severely criticised by economists on the
following grounds:

1. Profits uncertain: The principle of profit maximisation assumes that firms are
certain about the levels of their maximum profits. But profits are most uncertain for they
accrue from the difference between the receipt of revenues and incurring of costs in the
future. It is, therefore, not possible for firms to maximise their profits under conditions of
uncertainty.

2. No relevance to internal organisation: This objective of the firm bears little or no


direct relevance to the internal organisation of firms. For instance, some managers incur
expenditures apparently in excess of those that would maximise wealth or profits of the
owners of the firm. Managers of corporations are observed to emphasize growth of total
assets of the firm and its sales as objectives of managerial actions. Also managers of firms
undertake cost reducing, efficiency increasing campaigns when demand falls.

3. No perfect knowledge: The profit maximisation hypothesis is based on the


assumption that all firms have perfect knowledge not only about their own costs and revenues
but also of other firms. But, in reality, firms do not possess sufficient and accurate knowledge
about the conditions under which they operate. At the most they may have knowledge about
their own costs of production, but they can never be definite about the market demand curve.
They always operate under conditions of uncertainty and the profit maximisation theory is
weak in that it assumes that firms are certain about everything.

4. Empirical evidence vague: The empirical evidence on profit maximisation is vague.


Most firms do not rank profits as the major goal. The working of modem firms is so complex
that they do not think merely about profit maximisation. Their main problems are of control
and management. The function of managing these firms is performed by managers and
shareholders rather than by the entrepreneurs. They are more interested in their emoluments
and dividends respectively. Since there is substantial separation of ownership from control in
modern firms, they are not operated so as to maximise profits.

5. Firms do not bother about MC and MR: It is asserted that the real world firms do
not bother about the calculation of marginal revenue and marginal cost. Most of them are not
even aware of the two terms. Others do not know the demand and marginal revenue curves
faced by them. Still others do not possess adequate information about their cost structure.
Empirical evidence by Hall and Hitch shows that businessman have not heard of marginal
cost and marginal revenue. After all, they are not greedy calculating machines.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

6. Principle of average-cost maximises profits: Hall and Hitch found that firms do not
apply the rule of equality of MC and MR to maximise short run profits. Rather, they aim at
the maximisation of profits in the long run. For this, they do not apply the marginalistic rule
but they fix their prices on the average cost principle. According to this principle, price
equals AVC+AFC+ profit margin (usually 10%). Thus the main aim of the profit maximising
firm is to set a price on the average cost principle and sell its output at that price.

7. Static theory: The neo-classical theory of the firm is static in nature. The theory
does not tell the duration of either the short period or the long period. The time-horizon of the
neo-classical firm consists of identical and independent time-periods. Decisions are
considered as independent of the time-period. This is a serious weakness of the profit
maximisation theory. In fact, decisions are „temporally interdependent‟. It means that
decisions in any one period are affected by decisions in past periods which will, in turn,
influence the future decisions of the firm. This interdependence has been ignored by the neo-
classical theory of the firm.

8. Not applicable to oligopoly firm: As a matter of fact, the profit maximisation


objective has been retained for the perfectly competitive, or monopolistic, or monopolistic
competitive firm in economic theory. But it has been abandoned in the case of the oligopoly
firm because of the criticisms leveled against it. Hence the different objectives that have been
put forth by economists in the theory of the firm relate to the oligopoly or duopoly firm.

9. Varied Objectives: The basis of the difference between the objectives of the neo-
classical firm and the modern corporation arises from the fact that the profit maximisation
objective relates to the entrepreneurial behaviour while modern corporations are motivated by
different objectives because of the separate roles of shareholders and managers. In the latter,
shareholders have practically no influence over the actions of the managers.

Sales Maximization

According to Baumol, with the separation of ownership and control in modern


corporations, managers seek prestige and higher salaries by trying to expand company sales
even at the expense of profits. Being a consultant to a number of firms, Baumol observes that
when asked how their business went last year, the business managers often respond, “Our
sales were up to three million dollars”. Thus, according to Baumol, revenue or sales
maximisation rather than profit maximisation is consistent with the actual behaviour of firms.
Baumol cites evidence to suggest that short-run revenue maximisation may be consistent with
long-run profit maximisation. But sales maximisation is regarded as the short-run and long-
run goal of the management. Sales maximisation is not only a means but an end in itself.

He gives a number of arguments in support of his theory.

1. A firm attaches great importance to the magnitude of sales and is much concerned
about declining.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

2. If the sales of a firm are declining, banks, creditors and the capital market are not
prepared to provide finance to it.
3. Its own distributors and dealers might stop taking interest in it.
4. Consumers might not buy its product because of its unpopularity.
5. Firm reduces its managerial and other staff with fall in sales.
6. But if firm‟s sales are large, there are economies of scale and the firm expands and
earns large profits.
7. Salaries of workers and management also depend to a large extent on more sales
and the firm gives them bonus and other facilities.
By sales maximisation, Baumol means maximisation of total revenue. It does not
imply the sale of large quantities of output, but refers to the increase in money sales (in rupee,
dollar, etc.). Sales can increase up to the point of profit maximization where the marginal cost
equals marginal revenue. If sales are increased beyond this point money sales may increase at
the expense of profits. But the oligopolistic firm wants its money sales to grow even though it
earns minimum profits. Minimum profits refer to the amount which is less Quantity than
maximum profits.
The minimum profits are determined on the basis of firm‟s need to maximize sales
and also to sustain growth of sales. Minimum profits are required either in the form of
retained earnings or new capital from the market. The firm also needs minimum profits to
finance future sales. Further, they are essential for a firm for paying dividends on share
capital and for meeting other financial requirements.

Sales Maximization

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

Managerial Decision Making Process

Decision making is crucial for running a business enterprise which faces a large
number of problems requiring decisions. Which product to be produced, what price to be
charged, what quantity of the product to be produced, what and how much advertisement
expenditure to be made to promote the sales, how much investment expenditure to be
incurred are some of the problems which require decisions to be made by managers.

The five steps involved in managerial decision making process are explained below:

1. Establishing the Objective: The first step in the decision making process is to
establish the objective of the business enterprise. The important objective of a private
business enterprise is to maximise profits. However, a business firm may have some other
objectives such as maximisation of sales or growth of the firm. But the objective of a public
enterprise is normally not of maximisation of profits but to follow benefit-cost criterion.
According to this criterion, a public enterprise should evaluate all social costs and benefits
when making a decision whether to build an airport, a power plant, a steel plant, etc.

2. Defining the Problem: The second step in decision making process is one of
defining or identifying the problem. Defining the nature of the problem is important because
decision making is after all meant for solution of the problem. For instance, a cotton textile
firm may find that its profits are declining. It needs to be investigated what are the causes of
the problem of decreasing profits. Once the source or reason for falling profits has been
found, the problem has been identified and defined.

3. Identifying Possible Alternative Solutions (i.e. Alternative Courses of Action):


Once the problem has been identified, the next step is to find out alternative solutions to the
problem. This will require considering the variables that have an impact on the problem. In
this way, relationship among the variables and with the problems has to be established.

In regard to this, various hypotheses can be developed which will become alternative
courses for the solution of the problem. For example, in case of the problem mentioned
above, if it is identified that the problem of declining profits is due to be use of
technologically inefficient and outdated machinery in production.

The two possible solutions of the problem are:

(1) Updating and replacing only the old machinery.

(2) Building entirely a new plant equipped with latest machinery.

The choice between these alternative courses of action depends on which will bring
about larger increase in profits.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur


EAB - Unit I Notes

4. Evaluating Alternative Courses of Action: The next step in business decision


making is to evaluate the alternative courses of action. This requires the collection and
analysis of the relevant data. Some data will be available within the various departments of
the firm itself, the other may be obtained from the industry and government. The data and
information so obtained can be used to evaluate the outcome or results expected from each
possible course of action. Methods such as regression analysis, differential calculus, linear
programming, cost- benefit analysis are used to arrive at the optimal course. The optimum
solution will be one that helps to achieve the established objective of the firm. The course of
action which is optimum will be actually chosen. It may be further noted that for the choice
of an optimal solution to the problem, a manager works under certain constraints.

The constraints may be legal such as laws regarding pollution and disposal of harmful
wastes; they way be financial (i.e. limited financial resources); they may relate to the
availability of physical infrastructure and raw materials, and they may be technological in
nature which set limits to the possible output to be produced per unit of time. The crucial role
of a business manager is to determine optimal course of action and he has to make a decision
under these constraints.

5. Implementing the Decision: After the alternative courses of action have been
evaluated and optimal course of action selected, the final step is to implement the decision.
The implementation of the decision requires constant monitoring so that expected results
from the optimal course of action are obtained. Thus, if it is found that expected results are
not forthcoming due to the wrong implementation of the decision, then corrective measures
should be taken. However, it should be noted that once a course of action is implemented to
achieve the established objective, changes in it may become necessary from time to time in
response in changes in conditions or firm‟s operating environment on the basis of which
decisions were taken.

Dr K R Kumar, Associate Professor in MBA, Adhiyamaan College of Engineering (Autonomous), Hosur