EE&FA Unit 1

Engineering Economics & Financial Analysis (MG 2452)

INTRODUCTION Managerial Economics Relationship with other disciplines Firms: types, objectives and goals Managerial decisions Decision analysis Economics and Finance are the language of business. An understanding of both these disciplines help engineers to be more effective in their jobs as they rise up in their organization and shoulder higher responsibilities. Every decision in an organization has a financial implications and every organization operates within a system. An understanding of how the system works helps a person managing an organization to take informed decisions. 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.

What is economics?
Economics is the study of how human beings in a society go about achieving their wants and desires. It studies how wealth (money) is produced with limited resources in order to satisfy human wants. It is also defined as the study of allocation of scarce resources to satisfy individual wants or desires.
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.

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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. Economics is a social science. Its basic function is to study how people, individual households, firms and nations maximize their gains from their limited resources and opportunities. In economic terminology it is called as maximizing behaviour or more appropriately optimizing behaviour. Optimizing means selecting best out of available resources with the objective of maximizing gains from given resources. The term economics is derived from two Greek words OIKOS (a house) and NEMEIN (to manage). Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses Lionel Robbins Economics is a social science concerned chiefly with the way society chooses to employ its resources. Which have alternative uses, to produce goods and services for present and future consumption Samuelson Scarcity and uncertainty are the two foundation stones of economics. Anything which commands a price is a scarce item, called an economic good, and the rest are free goods. A commodity which is free good today in a particular society might become an economic good tomorrow in the same society or might even be an economic good today in some other society. For example, water which was a free good, has a price tag now in many cities but it is still a free good in most rural areas.

What is Positive and Normative Economics? Positive economics can be defined as a body of systematized knowledge concerning what is; while normative economics tries to develop criteria for what ought to be. Positive economics is mainly concerned with the description of economic events and it tries to formulate theories to explain them. But in normative economics, we give more importance to ethical judgments. Normative economics is concerned with the ideal rather than the actual situation. In simple terms, positive analysis is what it is and normative analysis is what it should be. For example, CEOs in private Indian enterprises earn 15 times as much as the lowest paid employee is a positive statement, a description of what is. A normative statement would be that CEOs should be paid 4-5 times the lowest paid employee.

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How
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.

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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.

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).
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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.

Limitations of macro economics

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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.

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
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There are number of macro economic policies 1. Monetary policy 2. Fiscal policy 3. Income policy 4. Trade policy 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. Theory of distribution 4. Theory of consumption function 5. Theory of investment 6. Theories of trade cycles 7. Theories of economic growth 8. Theories of inflation 9. Theories of monetary policy 10.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).
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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)

What is Managerial Economics?

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. A close relationship between management and economics has led to the development of managerial economics. Management is the guidance, leadership and control of the efforts of a group of people towards some common objective. Formerly it was known as Business Economics but the term has now been discarded in favour of Managerial Economics. 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.

Define Managerial Economics

Managerial Economics is economics applied in decision making. It is a
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special branch of economics bridging the gap between abstract theory and managerial practice. Haynes, Mote and Paul. 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
A common thread runs through all these descriptions of managerial economics which is using a framework of analysis to arrive at informed decisions to maximize the firms objectives, often in an environment of uncertainty. It is important to recognize that decisions taken while employing a framework of analysis are likely to be more successful than decisions that are knee jerk or gut feel decisions.

Nature of Managerial Economics:

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, raw-materials 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.
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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.

The basic characteristics of managerial economics can now be enumerated as: It is concerned with decision making of an economic nature. It is micro-economic in character. It largely uses that body of economic concepts and principles, which is known as theory of the firm. It is goal oriented and prescriptive Managerial economics is both conceptual and metrical. It includes theory with measurement.

Relationship disciplines

of

Managerial

Economics

with

other

Managerial economics is linked with various other fields of study like

1. Microeconomic Theory: As stated in the introduction, the roots of managerial economics spring from micro-economic theory. Price theory, demand concepts and theories of market structure are few elements of micro economics used by managerial economists. It has an applied bias as it applies economic theories in order to solve real world problems of enterprises. 2. Macroeconomic Theory: This field has little relevance for managerial economics but at least one part of it is incorporated in managerial economics i.e. national income forecasting. The latter could be an important aid to business condition analysis, which in turn could be a valuable input for forecasting the demand for specific product groups. 3. Operations Research: This field is used in managerial economics to find out the best of all possibilities. Linear programming is a great aid in decision making in business and industry as it can help in solving problems like determination of facilities on machine scheduling, distribution of commodities and optimum product mix etc. 4. Theory of Decision Making: Decision theory has been developed to deal with problems of choice or decision making under uncertainty, where the applicability of figures required for the utility calculus are not available. Economic theory is based on assumptions of a single goal whereas decision theory breaks new grounds by recognizing multiplicity of goals and persuasiveness of uncertainty in the real world of management. 5. Statistics: Statistics helps in empirical testing of theory. With its help, better decisions relating to demand and cost functions, production, sales or distribution are taken. Managerial economics is heavily dependent on statistical methods. 6. Management Theory and Accounting: Maximisation of profit has been regarded as a central concept in the theory of the firm in microeconomics. In recent years, organisation theorists have talked about satisficing instead of maximising as an objective of the enterprise. Accounting data and statements constitute the language of business. In fact the link is so close that managerial accounting has developed as a separate and specialized field in itself. 10

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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.

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. Demand Analysis and Forecasting 2. Cost and Production Analysis 3. Pricing Decisions, Policies and Practices 4. Profit Management 5. Capital Management These divisions of business economics constitute its subject matter.
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
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various market forms, pricing methods, differential pricing, productline 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, profit-planning 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.

Finance:
Financial Accounting is primarily concerned with record-keeping directed towards the preparation of profit and loss account and the balance sheet. The main purposes of financial accounting are: a) Recording of the transactions concerning and affecting the business b) Preparation of necessary accounts and balance sheet as required by statutes; and c) Appraising the owners of the business about the results of the business over a period of time.
Meaning of Finance: Financial Management deals with the procurement of funds and their effective utilization in the business. The first basic function of financial management is procurement of funds and the other is their effective utilization. (i) Procurement of funds: Funds can be procured from different sources; their procurement is a complex problem for business concerns. Funds procured from different sources have different characteristics in terms of risk, cost and control. (ii) Effective utilisation of funds: Since all the funds are procured at a certain cost, therefore it is necessary for the finance manager to take appropriate and timely actions so that the funds do not remain idle. If these funds are not utilised in the manner so that they generate an income higher than the cost of procuring them then there is no point in running the business.
MO N EY REC O RD FIN AN CE FUN CTION C O N TRO L ADVI SO RY

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MAN AGEMEN T K EEPI N G & REPO RTI N G (AC C O UN TI N G) Fi nanc i al Ac c ounti n g C ost Ac c ounti n g Manage m e nt Ac c ounti n g Te chniq ue s Sys t e ms RO L E

Re sourc e mobi l i zati on W ork i ng C api tal Manage m e nt I nve stme nt Manage m e nt

B udge ts C ost C ontrol I nte rnal Audi t

Re sponsi bi l i ty C e ntre Profi t C e ntre C ost C e ntre I nve stme nt C e ntre

Pri c i ng Di vi de n d Pol i c y Val uati o n

Koontz and ODonell define management as the creation and maintenance of an internal environment in an enterprise where individuals, working together in groups, can perform efficiently and effectively towards the attainment of group goals. Thus, management is: Coordination An activity or an ongoing process A purposive process An art of getting things done by other people On the other hand, economics as stated above is engaged in analysing and providing answers to manifestations of the most fundamental problem of scarcity. Scarcity of resources results from two fundamental facts of life: Human wants are virtually unlimited and insatiable, and Economic resources to satisfy these human demands are limited. Thus, we cannot have everything we want; we must make choices broadly in regard to the following: What to produce? How to produce? and For whom to produce?

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Firms: types, objectives and goals What is a firm?

The concept of a firm plays a central role in the theory and practice of managerial economics. A firm is understood as an organization which converts inputs, which it hires, into outputs, which it sells. The inputs, called the factors of production (FOP) are classified as follows:

Four Factors of Production:

In economic terms, the four factors of production are referred to as land, labour, capital (man-made) and entrepreneur (organization) and the remuneration they receive as rent, wage, interest (capital rental) and profit respectively Under human resources, labour input includes both Physical and mental labour, i.e. both unskilled (blue collar) and skilled (white collar) labour and it is that part of human effort in an organization which is paid wages and salaries as remuneration. The other kind of human resource is entrepreneurial resource. An entrepreneur takes the initiative, coordinates, innovates and takes risk and receives as compensation profits or loss. Under land resource, land resource has a rather broad meaning in economics it includes all the resources created (gifted) by God. Thus, it consists of the barren land, minerals, forests, rivers, sea, mountains, etc. as initially discovered by mankind Any development work which mankind has carried over all these is part of man made capital. It includes all construction on land, like roads, bridges and buildings (residential as well as commercial). All the equipments such as plant, machines, tools and inventories which consist of unsold finished, semi-finished goods and raw materials.. The function of the firm, thus, is to purchase resources or inputs of labour services, capital and raw materials in order to convert them into goods and services for sale. There is a circular flow of economic activity between individuals and firms as they are highly interdependent. Labour has no value in the market unless there is a firm willing to pay for it. In the same way, firms cannot rationalise production unless some consumer is willing to buy their products. However, there is some incentive for each. Firms earn profits in turn satisfying the consumption demand of individuals and resource owners get wage, rent and interest payment. In the process of supplying the goods and services that consumers demand, firms provide employment to workers and also pay taxes that government uses to provide service (education, defense) that firms could not provide at all or as efficiently. Essentially a firm exists because the total cost of production of output is lower than if the firm did not exist. There are several reasons for lower costs. The firm changes hired inputs into saleable output. An input is defined as anything that the firm uses in its production process. Most firms require a 14

EE&FA Unit 1 wide array of inputs. For example, some of the inputs used by major steel firms like SAIL or TISCO are iron ore, coal, oxygen, skilled labour of various types, the services of blast furnaces, electric furnaces, and rolling mills as well as the services of the people managing the companies.

Types of Business Organisation

An organizations structure is defined by its configuration and interrelationships of positions and departments. The organizational design of a company reflects its efforts to respond to changes, integrate new elements, ensure collaboration, and allow flexibility. In the past, organizations were commonly structured as bureaucracies. A bureaucracy is a form of organization based on logic, order, and the legitimate use of formal authority. Bureaucracies are meant to be orderly, fair, and highly efficient. Their features include a clear-cut division of labor, strict hierarchy of authority, formal rules and procedures, and promotion based on competency. Today, many people view bureaucracies negatively and recognize that bureaucracies have their limits. If organizations rely too much on rules and procedures, they become unwieldy and too rigidmaking them slow to respond to changing environments and more likely to perish in the long run.

Firms are classified into different categories as follows:

a) Private sector firms. b) Public sector firms. c) Joint sector firms. d) Non-profit firms.

Firms can also be classified on the basis of number of owners as: a) Proprietorship. b) Partnership. c) Corporations. Some firms mentioned below are different from above. They may provide service to a group of clients for example, patients or to a group of its members only. a) Universities. b) Public Libraries. c) Hospitals. d) Museums. e) Churches. f) Voluntary Organisations. g) Cooperatives. h) Unions. i) Professional Societies, etc. Type of Business Organization ADVANTAGES DISADVANTAGES

A Sole Proprietorship consists of one individual doing business.

1. Sole proprietors are 15

1. Unlimited liability

EE&FA Unit 1 Type of Business Organization Sole Proprietorships The vast majority of small businesses start out as sole proprietorships . . . very dangerous. These firms are owned by one person, usually the individual who has day-today responsibility for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume "complete personal" responsibility for all of its liabilities or debts. In the eyes of the law, you are one in the same with the business. ADVANTAGES DISADVANTAGES

in complete control, within the law, to make all decisions. 2. Sole proprietors receive all income generated by the business to keep or reinvest. 3. Profits from the business flowthrough directly to the owner's personal tax return. 4. The business is easy to dissolve, if desired.

and are legally responsible for all debts against the business. 2. Their business and personal assets are 100% at risk. 3. Have almost the ability to raise investment funds. 4. Are limited to using funds from personal savings or consumer loans. 5. Have a hard time attracting highcaliber employees, or those that are motivated by the opportunity to own a part of the business. 6. Employee benefits such as owner's medical insurance premiums are not directly deductible from business income (partially deductible as an adjustment to income).

A Partnership is made up of two or more individuals doing business together. Partnerships In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The Partners should have a legal agreement that sets forth how decisions will be made, profits will

1. Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement. 2. With more than one 16

1. Partners are jointly and individually liable for the actions of the other partners. 2. Profits must be shared with others. 3. Since decisions are

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be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed. Yes, its hard to think about a "break-up" when the business is just getting started, but many partnerships split up at crisis times and unless there is a defined process, there will be even greater problems. They also must decide up front how much time and capital each will contribute, etc. Types of Partnerships that should be considered:

ADVANTAGES

DISADVANTAGES

owner, the ability to raise funds may be increased. 3. The profits from the business flow directly through to the partners' personal taxes. Prospective employees may be attracted to the business if given the incentive to become a partner.

shared, disagreements can occur. 4. Some employee benefits are not deductible from business income on tax returns. 5. The partnership has a limited life; it may end upon a partner withdrawal or death.

General Partnership Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently. Limited Partnership and Partnership with limited liability "Limited" means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short term projects, or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.

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EE&FA Unit 1 Type of Business Organization A corporation, chartered by the state in which it is headquartered, is considered by law to be a unique "entity", separate and apart from those who own it. A corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes. I. ADVANTAGES DISADVANTAGES

Shareholders have limited liability for the corporation's debts or judgments against the corporations.

1. The process of incorporation requires more time and money than other forms of organization.

II. Generally, 2. Corporations are shareholders can monitored by only be held federal, state and accountable for their some local agencies, investment in stock and as a result may of the company. have more (Note however, that paperwork to officers can be held comply with personally liable for regulations. their actions, such 3. Incorporating may as the failure to result in higher withhold and pay overall taxes. employment taxes.) Dividends paid to III. Corporations can shareholders are not raise additional deductible from funds through the business income, sale of stock. thus this income can be taxed twice. IV. A corporation may deduct the cost of benefits it provides to officers and employees. Can elect S corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership.

OBJECTIVE OF THE FIRM

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EE&FA Unit 1 The traditional objective of the firm has been profit maximisation. We define profits as revenues less costs. But the definition of cost is quite different for the economist than for an accountant. This accounting or business profit is what is reported in publications and in the quarterly and annual financial reports of businesses. The economist recognises other costs, defined as implicit costs. These costs are not reflected in cash outlays by the firm, but are the costs associated with foregone opportunities. Such implicit costs are not included in the accounting statements but must be included in any rational decision making framework. The economic profit equals the revenue of the firm minus its explicit costs and implicit costs. To arrive at the cost incurred by a firm, a value must be put to all the inputs used by the firm. Money outlays are only a part of the costs. As stated above, economists also define opportunity cost. Since the resources are limited, and have alternative uses, you must sacrifice the production of a good or service in order to commit the resource to its present use. For example, if by being the owner manager of your firm, you sacrifice a job that offers you Rs. 2,00,000 per annum, then two lakhs is your opportunity cost of managing the firm. The assignment of monetary values to physical inputs is easy in some cases and difficult in others. All economic costing is governed by the principle of opportunity cost. If the firm maximises profits, it must evaluate its costs according to the opportunity cost principle. Assigning costs is straightforward when the firm buys an input on a competitive market. Suppose the firm spends Rs. 20,000 on buying electricity. For its factory, it has sacrificed claims to whatever else Rs 20,000 can buy and thus the purchase price is a reasonable measure of the opportunity cost of using that electricity. The situation is the same for hired factors of production. However, a cost must be assigned to factors of production that the firm neither purchases, nor hires because it already owns them. The cost of using these inputs is implicit costs and has to be imputed. Implicit costs arise because the alternative (opportunity) cost doctrine must be applied to be firm. The profit calculated after including implicit as well as explicit costs in total cost is called economic profit. Profit plays two primary roles in the free-market system. First, it acts as a signal to producers to increase or decrease the rate of output, or to enter or leave an industry. Second, profit is a reward for entrepreneurial activity, including risk taking and innovation. In a competitive industry, economic profits tend to be transitory. The achievement of high profits by a firm usually results in other firms increasing their output of that product, thus reducing price and profit. Firms that have monopoly power may be able to earn above-normal profits over a longer period; such profit does not play a socially useful role in the economy. FUNDAMENTAL CONCEPTS THAT AID DECISIONS: i. Incremental concept

ii. The concept of time perspective iii. The discounting principle 19

EE&FA Unit 1 iv. The concept of opportunity cost v. The equi-marginal principle

Incremental concept:

Incremental cost and incremental revenue is more or less the same as Marginal cost and Marginal Revenue but there are slight differences. Marginal Revenue is the addition to the total revenue per unit of output change. Incremental Revenue simply measures the difference between old and new revenues.

IR = R2 R1 =V R
R2 R1 Q2 Q1 VR V Q

MR =

Suppose a firm manufacturing fountain pens and selling it at a price of Rs. 5 decides to reduce the price to Rs. 4. As a result sales increase from Rs. 1000 to Rs. 1500 pens. In this case the incremental and marginal revenues can be calculated as under: IR = R2 R1= (Rs. 4 X 1500 units) (Rs. 5 X 1000 units) = Rs. 6000 Rs. 5000 = Rs. 1000 MR = (6000-5000)/ (1500-1000) = 1000/500 = Rs. 2 Similarly incremental costs are additional costs incurred due to change in the nature of activity. These costs refer to any type of change, adding a new product, changing distribution channels, installing a new machine, expanding the marker area and so on. Incremental measures the difference between old and new costs. On the other hand, Marginal cost denotes the extra cost incurred in adding a unit of output. It is the per unit cost of the added units. Marginal cost has limited meaning. Incremental cost is very flexible referring to any kind of change, while marginal costs are calculated for unit changes in output. Incremental costs are additional costs due to a change in the nature of activity. These costs refer to any type of change; adding a new product, changing distribution channels, installing a new machine, expanding the market area, etc. Incremental cost measures the difference between the old and new total costs. It measures the impact of decision alternatives on the total costs. 20

EE&FA Unit 1 Marginal cost denotes the extra cost incurred in adding a unit of output. It is the per unit cost of the added units. Marginal cost has limited meaning. Incremental cost is very flexible referring to any kind of change, while marginal costs are calculated for unit changes in output. A manager always determines the worth of a decision on the basis of the criterion that IR>IC. A decision is profitable if it increases revenue more than it increases cost it reduces some costs more than it increases others it increases some resources more than it decreases others it decreases costs more than it decreases revenues.

IC = C2 C1 =VC
C2 C1 Q2 Q1 VC VQ

MC =

MC and MR are always defined in terms of unit changes in output. But incremental costs and revenues are not necessarily restricted to unit changes.

The firm is an organisation that produces a good or service for sale and it plays a central role in theory and practice of Managerial Economics. In contrast to nonprofit institutions like the Ford Foundation, most firms attempt to make a profit. There are thousands of firms in India producing large amount of goods and services; the rest are produced by the government and non-profit institutions. It is obvious that a lot of activities of the Indian economy revolve around firms.

Production is any activity that transforms inputs into output and is

applicable not only to the production of goods like steel and automobiles, but also to production of services like banking and insurance. Production refers to all activities which are undertaken to produce goods which satisfy human wants.

The selling price of a product is derived as shown below: a) Direct material cost + Direct labour cost + Direct expenses b) c) d) e)
= PRIME COST Prime cost + Factory overhead = FACTORY COST Factory cost + Office & Administrative Overhead = COST OF PRODUCTION Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLD Cost of goods sold + Selling & Distribution overheads = COST OF SALES

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EE&FA Unit 1 f) Cost of sales + Profit g) Sales / Quantity sold

= SALES = SELLING PRICE PER UNIT

In the above calculations, if the opening stock of finished goods is equal to the closing stock of finished goods, then the cost of production is equal to the cost of goods sold.

What is Cost?
Ans: Cost refers to the summation of all costs incurred by the firm and revenues refer to the sale proceeds of goods and services. TYPES OF COST FIXED COSTS: The cost incurred in acquiring the fixed assets of the firm, viz. equipment, machinery, land, buildings permanent staff, etc. These inputs o =r factors of production can be used over a period of time VARIABLE COSTS: There are other inputs which are exhausted

MARGINAL COST: It is the cost of producing an additional unit of that product. Let the
cost of producing 20 units of the product be Rs. 10,000, and the cost of producing 21 units of the same product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45. MARGINAL REVENUE: The Marginal Revenue of a product is the incremental revenue of selling an additional unit of that product. Let the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21 units of the same product be Rs. 15,085. Then the marginal revenue of selling the 21st unit is Rs.85.

SUNK COST: This is known as the past cost of an equipment / asset. Let us assume that
an equipment has been purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present value of the equipment for further analysis. So, the purchase value of the equipment in the past is known as sunk cost.

What is Opportunity Cost?

Ans: OPPORTUNITY COST: Foregone contribution expected from the second best

alternative use of resources.

There is a conceptual difference in approach between an accountant and an economist. As far as revenues are concerned there is no disagreement, for there can be no dispute about whatever flows in as sale proceeds. But in calculating costs, both the accountant and the economist use a different approach. The accountant views the cost of an asset by taking into account the actual money spent on it. In short, it is the actual money spent in acquiring the same. It is the money spent or acquisition cost. But on the other hand, the economist views the cost in terms of Opportunity cost i.e. the cost of holding the factor from its alternative use. The economist analyses cost in terms of choice faced by the firm in utilizing its resources. The opportunity cost may be more than the acquisition cost or it may be less. In practice if a particular alternative(say X) is selected from a set of competing alternatives (say X, Y) then the corresponding investment in the selected alternative is not available for any other purpose. If the same money is invested in some other alternative (Y) it may fetch some return. Since the money has already been invested in the selected alternative X, one has to forego the return from the other alternative Y. The amount that is foregone by not investing the same money in another alternative.

What are the objectives of a firm?

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EE&FA Unit 1 Although, profit maximisation is a dominant objective of the firm, other important objectives of the firm, other than profit maximisation are: 1. Maximisation of sales revenue. 2. Maximisation of firms growth rate 3. Maximisation of managers own utility or satisfaction 4. Making a satisfactory rate of profit. 5. Long-run survival of the firm 6. Entry-prevention and risk avoidance. ALTERNATIVE OBJECTIVES OF FIRMS Economists have also examined other objectives of firms. We shall discuss some of them here. According to Baumol, most managers will try to maximise sales revenue. There are many reasons for this. For example, the salary and other earnings of managers are more closely related to sales revenue than to profits. Banks and financers look at sales revenue while financing the corporation. The sales revenue trend is a readily available indicator of performance of the firm. Growth in sales increases the competitive strength of the firm. However, in the long run, sales maximisation and profit maximisation may converge into one objective. VALUE MAXIMIZATION: Most firms have sidelined short-term profit as their objective. Firms are often found to sacrifice their short-term profit for increasing the future long-term profit. Thus, the theory states that the objective of a firm is to maximise wealth or value of the firm. The objective of the firm is thus to maximise the present or discounted value of all future profits and can be stated as:

Graphic representation of PV of Annuity of Re.1 @ 10%

End Time period0 1 of 2 the 3 year 4

Re.1 Re.1 Re.1 Re.1 0.909 0.826 0.751 0.683 -------Total Rs.(PV) 3.169 =====
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Rs. Rs. Rs. Rs.

EE&FA Unit 1

Present value of a Future Cash Flow (Inflow or Outflow) is the amount of current cash that is of equivalent value to the decision maker. Discounting is the process of determining present values of a series of future cash flows. The Present Value (PV) of Rs. 4 received over a period of 4 years is Rs.3.169 (discounted @10%) The compound interest rate used for discounting cash flows is called the discount rate

Discounted Cash Flow (DCF) is what someone is willing to pay today

in order to receive cash flow of future years. The DCF method converts future earnings in todays money. The Future Cash Flows must be recalculated (discounted) to represent their present values. In this way the value of a company or project under consideration as a whole is determined properly. The DCF method is an approach for valuation whereby projected cash flows are discounted at an interest rate (also called the rate of return) that reflects the perceived amount of risk of the cash flows. In fact the Discount Rate reflects two things:
1. The Time value of money Any investor would prefer to have cash

immediately than having to wait. Therefore, investors must be compensated by paying for the delay. 2. A Risk Premium that represents the extra return which investors demand for the risk that the cash flow might not materialize.
Whatever product or service a company offers it must meet the customers wants in the most satisfactory manner. This should be the aim of the company. A company has to continuously upgrade itself on several parameters: production efficiency, product development, quality management and marketing skills. This competitiveness - defined by Michael Porter as the sustained ability to generate more value for customers than the cost of creating that value - is what will keep Indias Companies alive in the bitter battle for survival that they are waging even on their home turf with rivals pouring in from all corners of the globe.

FIRMS CONSTRAINTS
Decision-making by firms takes place under several restrictions or constraints, such as: 24

EE&FA Unit 1 Resource Constraints: Many inputs may be available in a limited or fixed quantity e.g., skilled workers, imported raw material, etc. Legal Constraints: Both individuals and firms have to obey the laws of the State as well as local laws. Environmental laws, employment laws, disposal of wastes are some examples. Moral Constraints: These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviour. Contractual Constraints: These bind the firm because of some prior agreement such as a long-term lease on a building or a contract with a labour union that represents the firms employees. Decision-making under these constraints with optimal results is a fundamental part of managerial economics. MARGINAL UTILITY: In ordinary language utility means usefulness. But in economics utility is defined as the power of a commodity or a service to satisfy a human want. Utility is a subjective or psychological concept. Mutton for a vegetarian has no utility. Warm clothes have little utility for people living in the tropics. So utility depends on the consumer and the need for the commodity/ service. Total utility refers to the sum of utilities of all units of a commodity consumed. Marginal utility is the addition made to the total utility by consuming one more unit of a commodity. Law of Diminishing Marginal Utility : If a consumer takes more and more units of a commodity, the additional utility he derives from an extra unit of the commodity goes on falling. Thus the marginal utility decreases with the increase in the consumption of a commodity. When the marginal utility decreases the Total Utility increases at a diminishing rate. Explanation: Suppose Mr. X is hungry and eats apples one by one. The first apple gives great pleasure (high utility) as he is hungry. When he takes the second apple, the extent of hunger reduces. Therefore, he will derive less utility from the second apple. In this way, the additional utility (marginal utility) from the extra unit will go on decreasing. If the consumer continues to take more apples, the marginal utility falls to zero and becomes negative. No. of Total Marginal apples Utility Utility 1 2 3 4 5 6 7 20 35 45 50 50 45 35 20 15 10 5 0 -5 -10

RELATIONSHIP BETWEEN TOTAL UTILITY & MARGINAL UTIITY MARGINAL TOTAL UTILITY UTILITY Declines Increases 25

EE&FA Unit 1

Reaches Zero Becomes negative

Reaches maximum Declines

T
THE EQUI-MARGINAL PRINCIPLE
The idea of equi-marginal principle was first mentioned by HH Gossen of Germany, hence it is called Gossens Second Law. The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one commodity. Consumers wants are unlimited but consumers income available to satisfy the wants is limited. This law explains how the consumer spends his limited income on various commodities to get maximum satisfaction According to this principle, different courses of action should be pursued up to the point where all the courses provide equal marginal benefit per unit of cost. It states that a rational decision-maker would allocate or hire his resources in such a way that the ratio of marginal returns and marginal costs of various uses of a given resource or of various resources in a given use is the same.

50

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EE&FA Unit 1 This law is also known as the Law of substitution or Law of Maximum satisfaction or Principle of proportionality between prices and Marginal Utility Explanation: Suppose there are two goods X and Y on which a consumer has top spend his limited income. The consumer being rational he will spend his limited income on goods X and Y to maximize his total utility of satisfaction. Only at that point the consumer will be in equilibrium. Symbolically, the consumer will be in equilibrium when:

MU X MUY = = MU M PX PY
Where: MUX = Marginal utility of commodity X PX = Price of commodity X MUY = Marginal utility of commodity Y PY = Price of commodity Y MUM = Marginal utility of Money and are known as Marginal Utility of money expenditure

MU X PX

MUY PY

If a person has a thing which can be put to several uses, he will distribute it among these uses in such a way, that it has the same Marginal Utility in all Prof. Marshall The equi-marginal principle can be applied only where: i. Firms have limited investible resources ii. Resources have alternative uses, and iii. The investment in various alternative uses is subject Managerial decisions Managerial Economics (ME) serves as a link between traditional economics and the decision making sciences for business decision making. ME is a systematic way of thinking, approaching, analyzing managerial decisions. The focus of managerial economics is on how the firm reacts to changes in the economic environment in which it operates and how it predicts these changes and devises the best possible strategies to achieve the objectives that underlie its existence. ME focuses on the prescriptive approach to managerial decision, meaning an applied approach (instead of theoretical) to analyzing practical decisions actually faced by businesses and governments. Most of the analytical methods covered in ME were developed in response to important, actual real-world, recurring managerial decisions, such as optimal pricing (e.g., pricing in the airline industry taking into account consumer demand, profit maximization, elasticity, rivals reactions), forecasting (Maruti forecasting demand to determine optimal production, pricing, advertising, etc.), capital budgeting (Price Volume comparison of current costs versus expected future benefits), cost-benefit analysis of regulation or legislation, etc.

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EE&FA Unit 1 Decision analysis

Decision making forms the core of managerial economics. Decision making is the process of selecting a particular course of action among various alternatives. Every manager has to work on uncertainties and the future cannot be precisely predicted by anyone. If everything could be predicted accurately, then decision making would become a very simple process. Because of the presence of uncertainty, the decision maker must be very careful in choosing a particular course of action in order to realize the objectives. The result may lead to either nonrealization of objective or complete realization of objective or partial realization of objective.

Decision-making: Meaning and its characteristics 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. Establish objectives 2. Specify the decision problem 3. Identify the alternatives 4. Evaluate alternatives 5. Select the best alternatives 6. Implement the decision 7. Monitor the performance 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 decisionmaking, 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 for the decision problem. The essential elements in a decision making process include the following:
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EE&FA Unit 1

1. The decision maker, 2. The decision problem, 3. The environment in which the decision is to be made, 4. The objectives of the decision maker, 5. The alternative courses of action, 6. The outcomes expected from various alternatives, and 7. 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. 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
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EE&FA Unit 1

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
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EE&FA Unit 1

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 one 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.
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EE&FA Unit 1

Peter Drucker has laid down four criteria in order to weigh the consequences of various alternatives. They are:
(i)

(ii)

(iii)

(iv)

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. 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 never-ending 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
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EE&FA Unit 1

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:
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EE&FA Unit 1

(i) (ii) (iii)

if the decision is good one, one will know what to do, if faced with the similar problem again. If the decision is bad one, one will know what not to do, the next time. 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. Establish objectives 2. Specify the decision problem 3. Identify the alternatives 4. Evaluate alternatives 5. Select the best alternatives 6. Implement the decision 7. 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.

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