Engineering Economics & Financial Analysis (MG 2452)

INTRODUCTION  Managerial Economics  Relationship with other disciplines  Firms: types, objectives and goals  Managerial decisions  Decision analysis http://www.mbaknol.com/managerial-economics/basic-economic-tools-in-managerial-economics-fordecision-making/ When people want to communicate ideas they use language. Language is a medium of exchange. Without language people are reduced to physical touching or hand signals and have to be physically present with each other to communicate. With language people can exchange ideas with others in different centuries through books and in faraway places through the internet, newspapers and telephones. Sharing ideas leads to increasingly complex social agreements, concepts, inventions and discoveries, raising the standard of living and the level of expertise for the whole society. When people want to exchange goods they use money. Money is a medium of exchange. Without money the marketplace is limited. People are reduced to barter and have to be physically present with each other to exchange goods. The choice of goods is limited to what is physically available and valued in the moment ~ one cow for one cart, one tomato for two eggs, three pieces of cloth for one shovel. With money the choice of goods expands to include everything that is available in all places in the present and future. The marketplace of goods, opportunity and choice is as diverse as human expression.

Managerial Economics:
y Despite remarkable technological advances during the past several decades, most major engineering decisions are based on economic considerations-a situation that is unlikely to change in the years ahead. Hence the importance of economic principles to all engineering students, regardless of their particular disciplinary interests. One standard definition for economics is the study of the production, distribution, and consumption of goods and services. A second definition is the study of choice related to the allocation of scarce resources. The first definition indicates that economics includes any business, nonprofit organization, or administrative unit. The second definition establishes that economics is at the core of what managers of these organizations do.

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Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms.

Definition of Managerial Economics: Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul. Business Economics consists of the use of economic modes of thought to analyse business situations. McNair and Meriam Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management. Spencer and Seegelman. Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision. Mansfield Nature of Managerial Economics:
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The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, rawmaterials and power etc., are prepared. Forward planning and decision-making thus go on at the same time. A business managers task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty.

In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art.

Meaning of economics. Economics deals with a wide range of human activities to satisfy human wants. It deals with the society problems such as unemployment, poverty, productivity and government policies. It studies man in the ordinary business of life and how he earns his income and how he satisfies his wants. It is concerned (involves) not with individuals actions but with social actions. It studies about problems arising out of multiplicity (large number). It studies how wealth (money) is produced with limited resources in order to satisfy human wants.

Importance of the study of economics. The knowledge of economics helps in solving many problems. The knowledge of economics is essential to conquer (overcome a problem) poverty of the millions of people and to raise their standard of living. It explains the relationship between the producer and consumer, the labour and the management. It gives the businessmen and industrialists the knowledge of modern methods. By studying economics we can discover new factors that may lead to increase the national wealth. Without the knowledge of economics, this is absolutely impossible. The knowledge of economics is very essential for the finance minister.

a) It helps in framing the system of taxation. b) It helps in formulating the budget for development.

c) It helps in removing unemployment. Supply of money, effective credit system, effective working of the banking system can be analysed in the country only by having a thorough knowledge of economics by the people who admire these sectors. The knowledge of economics is very essential for the legislators and parliamentarians. They will be able to frame laws effectively only by having knowledge of the subject. The study is not undertaken merely for the sake of knowledge. It is to lay down principles and policies for removing poverty and increasing human welfare.

Economics as a science The question whether economics is a science or an art arose as early as the 18th century. A science is commonly defined as a systematic body of knowledge. A science teaches us to know. In other words science explains. Science is theoretical (a set of ideas needed to explain something or makes use of research findings to solve problems). Economics satisfies the test of science, it is rightly considered as a science.

Economics as an art An art is completely different from science. An art is a system of rules. An art teaches us to do. In other words art directs. Art is practical (involvement or even skills are also needed to understand). From this we can conclude that economics is an art.

Economics has both theoretical and practical sides. Science requires art, art requires science. Micro Economics The term mikros in Greek means small. Micro economics refers to the study of small units. In other words, micro economics studies the individual parts or components of the whole economy. Micro- economics is the study of particular firms, particular households, individual prices, wages, income, individual industries and so on.

Micro economics as the name implies is concerned with parts of the economy rather than with the economy as a whole.

Importance of micro economics It explains how the market economy operates. It explains the method or manner in which scarce resources are allocated for different uses. It explains how goods and services are produced and distributed to the people. Areas covered by micro economics are

a) Theory of product pricing b) Theory of factor pricing (rent, wages, interest and profits) c) Theory of economic welfare (happiness and safety). Limitations of micro economics It may not give an idea about the functioning of the whole economy. The results of micro economics studies may not be applicable to aggregates (total or whole). It fails to give correct guidance to government to formulate economic policies.

Macro economics The term macros in Greek means large. Macro economics is the study of aggregates (total or whole). It studies about aggregate (total) demand, aggregate consumption, aggregate production, aggregate income and aggregate investment, etc. It studies all parts or components of the whole economy and it is not concerned with individual aspects of the economy. Macro economics examines the forest and not the trees. Macro economics deals

a) not with individual quantities but with aggregate of these quantities, b) not with individual income but with national income, c) not with individual outputs but with total outputs.

Importance of macro economics It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic. It deals with many economic problems such as unemployment, inflation, depression (make very unhappy, push down or make less active) & recession (a temporary decline or loss in economic activity). It is used as a tool to analyse the level of employment, level of prices, etc. It is useful for the government in formulating suitable economic policies regarding general price level, wages, etc. It is only through macroeconomic approach the problems of economic growth could be solved. All nations, particularly developing nations are eager to increase their national income within the concern of macro economics. Areas covered by macro economics are a) Theory of income, output and employment. b) Theory of prices c) Theory of economic growth d) Theory of distribution. Importance of macro economics in points 1. Functioning of whole economy 2. Formulation of economic policies 3. Understanding & controlling economic fluctuations 4. Understanding macro economics 5. Inflation & deflation 6. Study of national income 7. Study of economic development

8. Performance of an economy 9. Nature of material welfare ( nature & size of the nations) Limitations of macro economics Macro analysis cannot be precise because it deals with aggregates (total) which are divergent (avoiding common assumptions in making deductions) in nature. In aggregative (total) thinking the elements have to be chosen carefully. (For e.g.) adding all fruits together is a meaningful aggregate. Adding fruits with other machinery is an absurd (unreasonable) aggregate. (i.e.) apple+ bike Macro analysis may reveal (make known) that the national income of the country has increased by 50%, but the real fact will be that a good majority of people will be living in poverty. Composition of aggregates may be imperfect in macro analysis. (e.g.) Prices of many commodities would have fallen in the economy, but the prices of very essential (necessary) commodities might have risen many times. The limitations of macro analysis are in the nature of practical difficulties rather than inherent weakness.

Limitations of macro economics in points 1. Excessive thinking in terms of aggregates 2. Heterogeneous elements 3. Differences within aggregates 4. Aggregates must be functionally related 5. Limited applications

Macro economic policy Macroeconomic policy can be defined as a programme of action undertaken to control, regulate and manipulate macro economic variables to achieve the macroeconomic goals of the society Macro economics is, thus, a policy oriented subject. It deals with a number of policies of macro nature to solve many issues & problems.

A macroeconomic policy is, in fact an instrument of policing the economy to achieve certain economic goal. Macroeconomic policies have macroeconomic goals to fulfill. The macroeconomic goals include 1. Price stability 2. Economic stability 3. Exchange rate stability 4. Maintenance of full employment 5. Economic growth 6. Economic justice (law) 7. Improvement of standard of living 8. Eradication of poverty 9. Equilibrium in the balance of payments 10. Equitable distribution of national income (or) economic equity There are number of macro economic policies 1. Monetary policy 2. Fiscal policy 3. Income policy 4. Trade police 5. Industrial policy 6. Import- Export policy 7. Banking policy 8. Planning policy. Objective of macroeconomic policy in India 1. Achieving a growth rate of 5- 6 % per annum. 2. Creating job opportunities for unemployed & underemployed ( not having sufficient demanding paid work) 3. Removing economic disparity ( differences) 4. Eradication of poverty 5. Controlling inflation & price stabilization 6. Preventing balance of payments imbalances. Macro economic theories Macro economic theories provide explanation to inter relationship among different macro economic variables & issues relating to the problems. There are number of macro economic theories 1. Theory of income & employment 2. Theory of general price level

3. 4. 5. 6. 7. 8. 9. 10.

Theory of distribution Theory of consumption function Theory of investment Theories of trade cycles Theories of economic growth Theories of inflation Theories of monetary policy Theories of fiscal policy

Macro economic variables Variables- (often changing) These are macro-economic variables 1. National income (total income of the country is called national income) a) National product (it consists of all goods and services produced by the community (a group of people living together in a place) or firm and exchanged for money during a year). b) National dividend / income (a sum of money paid to a shareholder out of its profit, it consists of all the incomes, in cash and kind) c) National expenditure (the total spending or outlay of the firm or community (a group of people living together in a place) on goods and services produced during a given year). 2. Concept of employment 3. Consumption (it refers to total consumption of the household sector and firms) 4. Savings (it refers to savings of the community or firms as a whole) Savings = Total income total consumption 5. Investment (total investment of the firms) 6. Government expenditure (government sector spends on consumption and investment) 7. Households (household sector includes all consuming) 8. Firms (firm sector includes all producing) 9. Economic sector (the entire economy is subdivided into four major sector) a) Primary (agricultural) b) Secondary (industries and manufacturing activities) c) Tertiary (services, such as professions banking, trade etc. activities) d) Foreign or external (refers to rest of the world, international trade) 10. Price level (price of goods in general) 11. Aggregate demand (demand for all goods and services) 12. Aggregate supply (supply of all goods and services in general)

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics: 1. 2. 3. 4. 5. Demand Analysis and Forecasting Cost and Production Analysis Pricing Decisions, Policies and Practices Profit Management Capital Management

These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics. 1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics. 2. Cost and production analysis: A firms profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control. 3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting. 4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profitplanning and profit measurement constitute the most challenging area of Managerial Economics.

5. Capital management: The problems relating to firms capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects. Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of Managerial Economics consists of applying economic principles and concepts towards adjusting with various uncertainties faced by a business firm. In Economics, use of the word demand is made to show the relationship between the prices of a commodity and the amounts of the commodity which consumers want to purchase at those price. Definition of Demand: Hibdon defines, Demand means the various quantities of goods that would be purchased per time period at different prices in a given market. Bober defines, By demand we mean the various quantities of given commodity or service which consumers would buy in one market in a given period of time at various prices, or at various incomes, or at various prices of related goods. Demand for product implies: a) desires to acquire it, b) willingness to pay for it, and c) Ability to pay for it. All three must be checked to identify and establish demand. For example : A poor mans desires to stay in a five-star hotel room and his willingness to pay rent for that room is not demand, because he lacks the necessary purchasing power; so it is merely his wishful thinking. Similarly, a misers desire for and his ability to pay for a car is not demand, because he does not have the necessary willingness to pay for a car. One may also come across a well-established person who processes both the willingness and the ability to pay for higher education. But he has really no desire to have it, he pays the fees for a regular cause, and eventually does not attend his classes. Thus, in an economics sense, he does not have a demand for higher education degree/diploma. It should also be noted that the demand for a product-a commodity or a servicehas no meaning unless it is stated with specific reference to the time, its price, price of is related goods, consumers income and tastes etc. This is because demand, as is used in Economics, varies with fluctuations in these factors.

To say that demand for an Atlas cycle in India is 60,000 is not meaningful unless it is stated in terms of the year, say 1983 when an Atlas cycles price was around Rs. 800, competing cycles prices were around the same, a scooters prices was around Rs. 5,000. In 1984, the demand for an Atlas cycle could be different if any of the above factors happened to be different. For example, instead of domestic (Indian), market, one may be interested in foreign (abroad) market as well. Naturally the demand estimate will be different. Furthermore, it should be noted that a commodity is defined with reference to its particular quality/brand; if its quality/brand changes, it can be deemed as another commodity. To sum up, we can say that the demand for a product is the desire for that product backed by willingness as well as ability to pay for it. It is always defined with reference to a particular time, place, price and given values of other variables on which it depends. Demand Function and Demand Curve Demand function is a comprehensive formulation which specifies the factors that influence the demand for the product. What can be those factors which affect the demand? For example, Dx = D (Px, Py, Pz, B, W, A, E, T, U) Here Dx, stands for demand for item x (say, a car) Px, its own price (of the car) Py, the price of its substitutes (other brands/models) Pz, the price of its complements (like petrol) B, the income (budget) of the purchaser (user/consumer) W, the wealth of the purchaser A, the advertisement for the product (car) E, the price expectation of the user T, taste or preferences of user U, all other factors. Briefly we can state the impact of these determinants, as we observe in normal circumstances: i) Demand for X is inversely related to its own price. As price rises, the demand tends to fall and vice versa.

ii) The demand for X is also influenced by its related priceof goods related to X. For example, if Y is a substitute of X, then as the price of Y goes up, the demand for X also tends to increase, and vice versa. In the same way, if Z goes up and, therefore, the demand for X tends to go up. iii) The demand for X is also sensitive to price expectation of the consumer; but here, much would depend on the psychology of the consumer; there may not be any definite relation. This is speculative demand. When the price of a share is expected to go up, some people may buy more of it in their attempt to make future gains; others may buy less of it, rather may dispose it off, to make some immediate gain. Thus the price expectation effect on demand is not certain. iv) The income (budget position) of the consumer is another important influence on demand. As income (real purchasing capacity) goes up, people buy more of normal goods and less of inferior goods. Thus income effect on demand may be positive as well as negative. The demand of a person (or a household) may be influenced not only by the level of his own absolute income, but also by relative incomehis income relative to his neighbours income and his purchase pattern. Thus a household may demand a new set of furniture, because his neighbour has recently renovated his old set of furniture. This is called demonstration effect. v) Past income or accumulated savings out of that income and expected future income, its discounted value along with the present incomepermanent and transitoryall together determine the nominal stock of wealth of a person. To this, you may also add his current stock of assets and other forms of physical capital; finally adjust this to price level. The real wealth of the consumer, thus computed, will have an influence on his demand. A person may pool all his resources to construct the ground floor of his house. If he has access to some additional resources, he may then construct the first floor rather than buying a flat. Similarly one who has a color TV (rather than a black-and-white one) may demand a V.C.R./V.C.P. This is regarded as the real wealth effect on demand. vi) Advertisement also affects demand. It is observed that the sales revenue of a firm increases in response to advertisement up to a point. This is promotional effect on demand (sales). Thus vii) Tastes, preferences, and habits of individuals have a decisive influence on their pattern of demand. Sometimes, even social pressurecustoms, traditions and conventions exercise a strong influence on demand. These socio-psychological determinants of demand often defy any theoretical construction; these are non-economic and non-market factorshighly indeterminate. In some cases, the individual reveal his choice (demand) preferences; in some cases, his choice may be strongly ordered. We will revisit these concepts in the next unit. You may now note that there are various determinants of demand, which may be explicitly taken care of in the form of a demand function. By contrast, a demand curve only considers the pricedemand relation, other things (factors) remaining the same. This relationship can be illustrated in the form of a table called demand schedule and the data from the table may be given a diagrammatic representation in the form of a curve. In other words, a generalized demand function is a multivariate function whereas the demand curve is a single variable demand function.

Dx = D(Px)

In the slopeintercept from, the demand curve which may be stated as Dx = + Px, where is the intercept term and relationship between Dx and Px. Suppose, = (-) 0.5, and = 10 Then the demand function is : D=10-0.5P Basic economic tools in managerial economics for decision making Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Following are the various steps in decision making process: 1. 2. 3. 4. 5. 6. 7. Establish objectives Specify the decision problem Identify the alternatives Evaluate alternatives Select the best alternatives Implement the decision Monitor the performance the slope which is negative because of inverse

Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal. Basic economic tools in managerial economics for decision making: Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision. Following are the basic economic tools for decision making: 1. 2. 3. 4. 5. Opportunity cost Incremental principle Principle of the time perspective Discounting principle Equi-marginal principle

1) Opportunity cost principle: By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g. a) The opportunity cost of the funds employed in ones own business is the interest that could be earned on those funds if they have been employed in other ventures. b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank. Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs. 2) Incremental principle: It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions.

The two basic components of incremental reasoning are 1. Incremental cost 2. Incremental Revenue The incremental principle may be stated as under: A decision is obviously a profitable one if
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it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues

3) Principle of Time Perspective Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations. For example; Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to managements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long run repercussion of the order is to be taken into account: 1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. 2) If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against. In the above example it is therefore important to give due consideration to the time perspectives. a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective. 4) Discounting Principle:

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/next year. Naturally he will chose Rs.100/- today. This is true for two reasonsi) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108 5) Equi marginal Principle: This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle. Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities. Decision-making: Meaning and its characteristics Decision-making is a process of selection from a set of alternative courses of action, which is thought to fulfill the objectives of the decision problem more satisfactorily than others. It is a course of action, which is consciously chosen for achieving a desired result. A decision is a process that takes place prior to the actual performance of a course of action that has been chosen. In terms of managerial decision-making, it is an act of choice, wherein a manager selects a particular course of action from the available alternatives in a given situation. Managerial decision making process involves establishing of goals, defining tasks, searching for alternatives and developing plans in order to find the best answer fo the decision problem. The essential elements in a decision making process include the following: 1. 2. 3. 4. 5. 6. 7. The decision maker, The decision problem, The environment in which the decision is to be made, The objectives of the decision maker, The alternative courses of action, The outcomes expected from various alternatives, and The final choice of the alternative.

Characteristics of decision-making: 1. It is a process of choosing a course of action from among the alternative courses of action. 2. It is a human process involving to a great extent the application of intellectual abilities. 3. It is the end process preceded by deliberation and reasoning.

4. It is always related to the environment. A manager may take one decision in a particular set of circumstances and another in a different set of circumstances. 5. It involves a time dimension and a time lag. 6. It always has a purpose. Keeping this in view, there may just be a decision not to decide. 7. It involves all actions like defining the problem and probing and analyzing the various alternatives, which take place before a final choice is made. Steps in rational decision making Effective decision-making process requires a rational choice of a course of action. There is a need to define the term rational here. Rationality is the ability to follow systematically, logical, thorough approach in decision making. Thus, if a decision is taken after thorough analysis and reasoning and weighing the consequences of various alternatives, such a decision will be called an objective or rational decision. Therefore rationality is the ability to follow a systematic, logical and thorough approach in decision-making process. Gross suggested three dimensions to determine rationality: (i) the extent to which a given action satisfies human interests; (ii) feasibility of means to the given end; (iii) consistency. Steps of decision-making process are given below: 1. Diagnosing and defining the problem: the first step in decision-making is to find out the correct problem. It is not easy to define the problem. It should be seen what is causing the trouble and what will be its possible solutions. Before defining a problem, a manager has to identify critical or strategic factor of the problem. Once the problem is properly defined then it will be easily solved. So, the first important factor is the determination of the problem. 2. Analysis of problem: after defining a problem, a manager should analyse it. He should collect all possible information about the problem and then decide whether it will be sufficient to take decision or not. Sometimes it may be costly to get additional information or further information may not be possible whatever information is available should be used to analyse the problem. Analyzing the problem involves classifying the problem and gathering information. Classification is necessary in order to know who should take the decision and who should be consulted in taking it. Without proper classification, the effectiveness of the decision may be jeopardized. The problem should be classified keeping in view the following factors: (i) the nature of the decision, i.e., whether it is strategic or it is routine. (ii) the impact of the decision on other functions, (iii) the futurity of the decision, (iv) the periodicity of the decision and (v) the limiting or strategic factor relevant to the decision. 3. Collection of data: in order to classify any problem, we require lot of information. So long as the required information is not available, any classification would be misleading. This will also have an adverse impact on the quality of the decision. Trying to analyse without facts is like guessing directions at a crossing without reading the highway signboards. Thus, collection of right type of information is very important in decision-making. It would not be an exaggeration to say that a decision is as good as the information on which it is based. Collection of facts and figures also requires certain decisions on the part of the manager. He must decide what type of information he requires and how he can obtain this. It is also important to note that when one gathers the facts to analyse a problem, he wants facts that relate to alternative courses of action. So one must know what the several alternatives are and then should collect information that will help in comparing the alternatives. Needless to say, collection of information is not sufficient; the manager must also know how to use it. It is not always possible to get all the information that is needed for defining and classifying

the problem. In such circumstances, a manager has to judge how much risk the decision involves as well as the degree of precision and rigidity that the proposed course of action can afford. It should also be noted that fact finding for the purpose of decision-making should be solution-oriented. The manager must lay down the various alternatives first and then proceed to collect fact, which will help in comparing alternatives. 4. Developing alternatives: after defining and analyzing the problem, the next step in the decision making process is the development of alternative courses of action. Without resorting to the process of developing alternatives, a manager is likely to be guided by his limited imagination. It is rare for alternatives to be lacking for any course of action. But sometimes, a manager assumes that there is only one way of doing a thing. In such a case, what the manager has probably not done is to force himself decision, which is the best possible. From this can be derived a key planning principle which may be termed as the principle of alternatives. Alternatives exist for every decision problem. Effective planning involves a search for the alternatives towards the desired goal. Once the manager starts developing alternatives, various assumptions come to his mind, which he can bring to the conscious level. Nevertheless, development of alternatives cannot provide a person with the imagination, which he lacks. But most of us have definitely more imagination than we generally use. It should also be noted that development of alternatives is no guarantee of finding the best possible decision, but it certainly helps in weighing one alternative against others and, thus, minimizing uncertainties. 5. Review of key factors: while developing alternatives, the principle of limiting factor has to be taken care of. A limiting factor is onw which stands in the way of accomplishing the desired goal. It is a key factor in decision-making. It such factors are properly identified, manager can confine his search for alternative to those, which will overcome the limiting factors. In choosing from among alternatives, the more an individual can recognize those factors which are limiting or critical to the attainment of the desired goal, the more clearly and accurately he or she can select the most favourable alternatives. It is not always necessary that the alternatives solutions should lead to taking some action. To decide to take no action is also a decision as much as to take a specific action. It is imperative in all organisational problems that the alternative of taking no action is being considered. For instance, if there is an unnecessary post in the department, the alternative not to fill it will be the best one. The ability to develop alternatives is often as important as making a right decision among the alternatives. The development of alternatives, if thorough, will often unearth so many choices that the manager cannot possibly consider them all. He will have to take the help of certain mathematical techniques and electronic computers to make a choice among the alternatives. 6. Selecting the best alternative: in order to make the final choice of the best alternative, one will have to evaluate all the possible alternatives. There are various ways to evaluate alternatives. The most common method is through intuition, i.e., choosing a solution that seems to be good at that time. There is an inherent danger in this process because a managers intuition may be wrong on several occasions. The second way to choose the best alternative is to weigh the consequences of one against those of the others. Peter Drucker has laid down four criteria in order to weigh the consequences of various alternatives. They are: (i) Risk: a manager should weigh the risks of each course of action against the expected gains. As a matter of fact, risks are involved in all the solution. What matters is the intensity of different types of risks in various solutions.

(ii)

(iii)

(iv)

Economy of effort: the best manager is one who can mobilize the resources for the achievement of results with the minimum of efforts. The decision to be chosen should ensure the maximum possible economy of efforts, money and time. Situation or timing: the choice of a course of a action will depend upon the situation prevailing at a particular point of time. If the situation has great urgency, the preferable course of action is one that alarms the organisation that something important is happening. If a long and consistent effort is needed, a slow start gathers momentum approach may be preferable. Limitation of resources: in choosing among the alternatives, primary attention must be given to those factors that are limiting or strategic to the decision involved. The search for limiting factors in decision-making should be a neverending process. Discovery of the limiting factor lies at the basis of selection from the alternatives and these are experience, experimentation and research and analysis which are discussed as: (a) Experience: in making a choice, a manager is influenced to a great extent by his past experience. Sometimes, he may give undue importance to past experience. He should compare both the situations. However, he can give more reliance to past experience in case of routine on his past experience to reach at a rational decision. (b) Experimentation: under this approach, the manager tests the solution under actual or simulated conditions. This approach has proved to be of considerable help in many cases in test marketing of a new product. But it is not always possible to put this technique into practice, because it is very expensive. It is utilized as the last resort after all other techniques of decision making have been tried. It can be utilized on a small scale to test the effectiveness of the decision. For instance, a company may test a new product in a certain territory before expanding its scale nationwide. (c) Research and analysis: it is considered to be the most effective technique of selecting among alternatives, where a major decision is involved. It involves a search for relationships among the more critical variables, constraints and premises that bear upon the goal sought. In a real sense, it is the pencil and paper approach to decision making. It weighs various alternatives by making models. It takes the help of computers and certain mathematical techniques. This makes the choice of the alternative more rational and objective.

7. Putting the decision into practice: the choice of an alternative will not serve any purpose if it not put into practice. The manager is not only concerned with taking a decision, but also with its implementation. He should try to ensure that systematic steps are taken to implement the decision. The main problem whi8ch the manager may face at the implementation stage is the resistance by the subordinates who are affected by the decision. If the manager is unable to overcome this resistance, the energy and efforts consumed in decision-making will go waste. In order to make the decision acceptable. It is necessary for the manager to make the people understand what the decision involves, what is expected of them and what they should expect from the management. The principle of slow and steady progress should be followed to bring a change in the behaviour of the

subordinates. In order to make the subordinates committed to the decision, it is essential that they should be allowed to participate in the decision making process. The managers, who discuss problems with their subordinates and give them opportunities to ask questions and make suggestions, find more support for their decisions than the managers who dont let the subordinates participate. Now the question arises at what level of the decision making process the subordinates should participate. The subordinates should not participate at the stage of defining the problem because the manager himself is not certain as to whom the decision will affect. The area where the subordinates should participate is the development of alternatives. They should be encouraged to suggest alternatives. This may bring to surface certain alternatives, which may not be thought of by the manager. Moreover, they will feel attached to the decision. At the same time, there is also a danger that a group decision may be poorer than the one-man decision. Group participation does not necessarily improve the quality of the decision, but sometimes impairs it. Someone has described group decision like a train in which every passenger has a brake. It has also been pointed out that all employees are unable to participate in decision-making. Nevertheless, it is desirable if a manager consults his subordinates while making decision. Participative management is more successful than the other styles of management. It will help in the effective implementation of the decision. 8. Follow up: it is better to check the results after putting the decision into practice. The reasons for the following up of decision are as follows: (i) if the decision is good one, one will know what to do, if faced with the similar problem again. (ii) If the decision is bad one, one will know what not to do, the next time. (iii) If the decision is bad and one follows up soon enough, corrective action may still be possible. In order to achieve proper follow up, the management should devise an efficient system of feedback information. This information will be very useful in taking the corrective measures and in taking right decisions in the future. Basic economic tools in managerial economics for decision making Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The steps below put managers analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Following are the various steps in decision making process: 1. 2. 3. 4. 5. 6. 7. Establish objectives Specify the decision problem Identify the alternatives Evaluate alternatives Select the best alternatives Implement the decision Monitor the performance

Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate

business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal. Basic economic tools in managerial economics for decision making: Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision. Following are the basic economic tools for decision making: 1. 2. 3. 4. 5. Opportunity cost Incremental principle Principle of the time perspective Discounting principle Equi-marginal principle

1) Opportunity cost principle: By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g. a) The opportunity cost of the funds employed in ones own business is the interest that could be earned on those funds if they have been employed in other ventures. b) The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. c) The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank. Its clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs. 2) Incremental principle: It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions. The two basic components of incremental reasoning are

1. Incremental cost 2. Incremental Revenue The incremental principle may be stated as under: A decision is obviously a profitable one if
y y y y

it increases revenue more than costs it decreases some costs to a greater extent than it increases others it increases some revenues more than it decreases others and it reduces cost more than revenues

3) Principle of Time Perspective Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations. For example; Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to managements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost(ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long run repercussion of the order is to be taken into account: 1) If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. 2) If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against. In the above example it is therefore important to give due consideration to the time perspectives. a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective. 4) Discounting Principle: One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- today or Rs.100/next year. Naturally he will chose Rs.100/- today. This is true for two reasons-

i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/- will become 108 5) Equi marginal Principle: This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be so allocated that the value added by the last unit is the same in all cases. This generalization is called the equi-marginal principle. Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labors services, viz, A,B,C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.