MANAGERIAL ECONOMICS
MODULE
1
Managerial Economics and Business economics are the two
terms, which, at times have been used interchangeably. Of late, however, the
term Managerial Economics has become more popular and seems to displace
progressively the term Business Economics.
It is sometimes referred to as business economics and is a
branch of economics that applies microeconomic analysis to decision methods of
businesses or other management units. As such, it bridges economic theory and
economics in practice.
Definition of Managerial
Economics
Managerial Economics
} "concerned with application of economic concepts and
economic analysis to the problems of formulating rational managerial decision”.
Edwin
Mansfield
We may, therefore define Managerial Economics as the discipline which deals with the application of economic theory to business management. Managerial Economics thus lies on the borderline between economics and business management and serves as a bridge between economics and business management.
Scope of Managerial economics
Managerial economics to a certain
degree is prescriptive in nature as it suggests course of action to a
managerial problem. Problems can be related to various departments in a firm
like production, accounts, sales, etc.
·
Demand decision
·
Production decision
Production decision
A firm needs to answer four basic questions - what to
produce, how to produce and how much to produce and for whom to produce.
What to produce?
A firm will produce according to its perception of the
customer demand. It can either produce consumer goods like food, clothing etc.
(which are for consumption purpose) or it can produce capital goods like
machinery etc. (which are for investment purposes).
How to produce?
Goods can be produced by certain techniques. Firms have the
option of producing goods by labour intensive technique and capital intensive
technique. Labour intensive technique is the one in which manual labour is used
to produce goods. Capital intensive technique is the one in which machinery
like forklift, assembly belts etc. are used to produce goods.
How much to produce?
A firm has to decide its production capacity and also how
much of their good a consumer needs and produce accordingly.
For whom to produce?
A firm has to decide its target population (i.e. to whom
they will serve products and/or services). Example, it will not be viable to
produce luxurious goods or middle income or low income group if they can't
afford it and produce basic necessity goods for rich class if they don't need
it. Therefore, a firm needs to match its produce according to the target
population it is serving
Demand decision
} Demand refers to the willingness to buy a commodity.
Demand, here, defines the market size for a commodity i.e. who will buy the
commodity. Analysis of the demand is important for a firm as its revenue,
profits, income of the employees depend on it.
Importance of Managerial Economics
The application of economics to business management or the integration of economic theory with business practice, as Spencer and Siegelman have put it, has the following aspects :-
1.
Reconciling traditional theoretical concepts of economics in
relation to the actual business behavior and conditions. In economic theory, the technique of analysis is one of
model building whereby certain assumptions are made and on that basis,
conclusions as to the behavior of the firms are drown. The assumptions,
however, make the theory of the firm unrealistic since it fails to provide a
satisfactory explanation of that what the firms actually do. Hence the need to
reconcile the theoretical principles based on simplified assumptions with
actual business practice and develops appropriate extensions and reformulation
of economic theory, if necessary.
2.
Estimating economic relationships, viz., measurement of various types of elasticities of
demand such as price elasticity, income elasticity, cross-elasticity,
promotional elasticity, cost-output relationships, etc. The estimates of these
economic relationships are to be used for purposes of forecasting.
3.
Predicting relevant economic quantities, eg., profit, demand, production, costs, pricing, capital,
etc., in numerical terms together with their probabilities. As the business
manager has to work in an environment of uncertainty, future is to be predicted
so that in the light of the predicted estimates, decision making and forward
planning may be possible.
4.
Using economic quantities in decision making and forward planning, that is, formulating business
policies and, on that basis, establishing business plans for the future
pertaining to profit, prices, costs, capital, etc. The nature of economic
forecasting is such that it indicates the degree of probability of various
possible outcomes, i.e. losses or gains as a result of following each one of
the strategies available. Hence, before a business manager there exists a
quantified picture indicating the number o courses open, their possible outcomes
and the quantified probability of each outcome. Keeping this picture in view,
he decides about the strategy to be chosen.
5.
Understanding significant external forces constituting the environment in which the business is
operating and to which it must adjust, e.g., business cycles, fluctuations in
national income and government policies pertaining to public finance, fiscal
policy and taxation, international economics and foreign trade, monetary
economics, labour relations, anti-monopoly measures, industrial licensing,
price controls, etc. The business manager has to appraise the relevance and
impact of these external forces in relation to the particular business unit and
its business policies.
Basic Economic Problems
The
fundamental problems faced by an economy can be summed up as follows:
What to Produce?
The
first major economic decision of any economy relates to the type and the range
of goods to be produced. Since resources are limited, one must choose between
different alternative combinations of goods and services that may be produced.
Allocation of resources between the different types of goods, e.g., consumer
goods and capital goods, is another major concern to any economy. At firm
level, this decision would involve review of market demand and availability of
raw materials and technology. This can also be referred to as the problem of
choice.
How to Produce?
Having
decided on what to produce, the economy must determine the techniques of
production to be used. This can also be viewed as the problem of efficiency;
efficiency is maximized when the limited stock of resources yields the maximum
possible volume of goods and services, or renders the maximum benefit to the
society. We would discuss the concept of efficiency subsequently in detail.
For whom to Produce?
This
means how the national product should be distributed. This is essentially the
problem of distribution. Once the goods are produced, they need to be
distributed among the various economic agents. In a market economy such a
distribution is done on the basis of “ability to pay” principle; this implies
that those who have more in terms of wealth and income would have more of the
commodities than those who have less. However, in a command economy such a
distribution is done on the basis of “according to need” principle; this
implies that people would be rewarded according to their needs and not their
ability to pay.
Are Resources used economically?
In
a world of scarcity, resources need to be efficiently employed. This is the
problem of economic efficiency or welfare maximization, dealt with by the
branch of economics known as welfare economics, the purpose of which is to
explain how a socially efficient allocation of resources can be identified and
achieved. At his level, let us be contended with the idea that resources would
be fully and efficiently employed if it is NOT possible to increase the output
of one commodity without reducing the output of another commodity. We would
also let you get a touch of this problem while discussion price and output
determination under different market forms.
Are Resources Fully Employed?
An
economy must Endeavour to achieve the fullest possible use of its available
resources, as unemployment of resources is equivalent to economic waster. The
economy should be so organized as to keep all factors of production (including
labour) fully employed. Keynes defined full employment as a situation in which
involuntary unemployment is reduced to the minimum possible level. Modern
economists like Marshall are of opinion that full employment should be a goal
of economic policy.
Is the Economy Growing?
Another
problem of any economy is to make sure that it keeps expanding or developing
with time, and that its productive capacity continues to increase, so that it
maintains conditions of stability. An economy seeks to achieve economic growth
mainly to improve the standards of living of its people, it is through economic
growth that an economy can get more of everything, without having less of
anything. There economic growth that an economy can get more of everything,
without having lees of anything. There are three major sources of growth:
growth of labour force, capital
formation and technological progress.
Characteristics of Managerial
Economics
1.
Managerial Economics is micro-economic in character.
2.
Managerial Economics largely uses
that body of economic concepts and
principles, which is known as 'Theory of
the firm' or 'Economics of the firm'. In addition, it also seeks to apply
Profit Theory, which forms part of Distribution Theories in Economics.
3.
Managerial Economics is pragmatic. It avoids difficult abstract
issues of economic theory but involves complications ignored in economic theory
to face the overall situation in which decisions are made. Economic theory
appropriately ignores the variety of backgrounds and training found in
individual firms but Managerial Economics considers the particular environment
of decision making.
4.
Managerial Economics belongs to normative economics rather than
positive economics (also sometimes known as Descriptive Economics). In other
words, it is prescriptive rather than descriptive. The main body of economic
theory confines itself to descriptive hypothesis, attempting to generalize
about the relations among different variables without judgment about what is
desirable or undesirable. For instance, the law of demand states that as price
increases. Demand goes down or vice-versa but this statement does not tell
whether the outcome is good or bad. Managerial Economics, however, is concerned
with what decisions ought to be made and hence involves value judgments.
Fundamental Concepts/Basic Economic
Tools
i.
Principle
of Opportunity cost
ii.
Principle
of Incremental cost
iii.
Principle
of Time perspective
iv.
Principle
of Discounting
v.
Equimarginal
Principle
Principle of
Opportunity cost
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 one’s 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.
It’s 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.
Principle of
Incremental cost
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
·
Incremental
cost
·
Incremental
Revenue
The incremental
principle may be stated as under:
“A decision is
obviously a profitable one if –
→
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”
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
management’s 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/-. Therefore 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”.
Principle of
Discounting
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, today’s Rs.100/- can be invested so as
to earn interest say as 8% so that one year after Rs.100/- will become 108.
Equimarginal
Principle
The equi-marginal principle was originally associated with consumption
theory and the
law is called ‘the law of equi-marginal utility’. The law of equi-marginal utility states that
a utility maximizing consumer distributes his consumption expenditure between various
goods and services he/she consumes in such a way that the marginal utility derived
from each unit of expenditure on various goods and services is the same. The pattern
of consumer’s expenditure maximizes a consumer’s total utility.
law is called ‘the law of equi-marginal utility’. The law of equi-marginal utility states that
a utility maximizing consumer distributes his consumption expenditure between various
goods and services he/she consumes in such a way that the marginal utility derived
from each unit of expenditure on various goods and services is the same. The pattern
of consumer’s expenditure maximizes a consumer’s total utility.
The law of equi-marginal principle has been applied to the allocation of resources
between their alternative uses with a view to maximizing profit in case a firm carries out
more than one business activity. This principle suggests that available resources
(inputs) should be so allocated between the alternative options that the marginal productivity gains (MP) from the various activities are equalized.
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.
Thus, a manger can make
rational decision by allocating/hiring resources in a manner which equalizes
the ratio of marginal returns and marginal costs of various uses of resources
in a specific use.
