EEampFA Unit 1

Engineering Economics amp 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 economicsEconomics 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

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 ldquomaximizing behaviourrdquo or more appropriately ldquooptimizing behaviourrdquo 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) ldquoEconomics is the science which studies human behaviour as a relationship between ends and scarce means which

have alternative usesrdquo Lionel Robbins ldquoEconomics 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 consumptionrdquo 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

1

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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 lsquowhat it isrsquo and normative analysis is lsquowhat it should bersquo 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

Importance of the study of economics

bull The knowledge of economics helps in solving many problems

bull The knowledge of economics is essential to conquer (overcome a problem) poverty of the millions of people and to raise their standard of living

bull It explains the relationship between the producer and consumer the labour and the management

bull It gives the businessmen and industrialists the knowledge of modern methods

bull 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

bull The knowledge of economics is very essential for the finance minister

2

EEampFA Unit 1

a) It helps in framing the system of taxation

b) It helps in formulating the budget for development

c) It helps in removing unemployment

bull 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

bull The term lsquomikrosrsquo 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

bull Micro- economics is the study of particular firms particular households individual prices wages income individual industries and so on

bull 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

bull It explains how the market economy operates

bull It explains the method or manner in which scarce resources are allocated for different uses

bull It explains how goods and services are produced and distributed to the people

bull 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

bull It may not give an idea about the functioning of the whole economy

bull The results of micro economics studies may not be applicable to aggregates (total or whole)

bull It fails to give correct guidance to government to formulate economic policies

Macro economics

bull The term lsquomacrosrsquo in Greek means large Macro economics is the study of aggregates (total or whole)

bull It studies about aggregate (total) demand aggregate consumption aggregate production aggregate income and aggregate investment etc

3

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bull It studies all parts or components of the whole economy and it is not concerned with individual aspects of the economy

bull Macro economics examines the forest and not the trees

bull 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

bull It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic

bull It deals with many economic problems such as unemployment inflation depression (make very unhappy push down or make less active) amp recession (a temporary decline or loss in economic activity)

bull It is used as a tool to analyse the level of employment level of prices etc

bull It is useful for the government in formulating suitable economic policies regarding general price level wages etc

bull It is only through macroeconomic approach the problems of economic growth could be solved

bull All nations particularly developing nations are eager to increase their national income within the concern of macro economics

bull 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

bull Macro analysis cannot be precise because it deals with aggregates (total) which are divergent (avoiding common assumptions in making deductions) in nature

bull In aggregative (total) thinking the elements have to be chosen carefully (For eg) adding all fruits together is a meaningful aggregate Adding fruits with other machinery is an absurd (unreasonable) aggregate (ie) apple+ bike

bull 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

4

EEampFA Unit 1

bull Composition of aggregates may be imperfect in macro analysis (eg) Prices of many commodities would have fallen in the economy but the prices of very essential (necessary) commodities might have risen many times

bull 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 ldquoa programme of action undertaken to control regulate and manipulate macro economic variables to achieve the macroeconomic goals of the societyrdquo

bull Macro economics is thus a policy oriented subject It deals with a number of policies of macro nature to solve many issues amp problems

bull A macroeconomic policy is in fact an instrument of policing the economy to achieve certain economic goal

bull Macroeconomic policies have macroeconomic goals to fulfill The macroeconomic goals include 1 Price stability2 Economic stability3 Exchange rate stability4 Maintenance of full employment5 Economic growth6 Economic justice (law)7 Improvement of standard of living8 Eradication of poverty9 Equilibrium in the balance of payments10 Equitable distribution of national income (or) economic equity

There are number of macro ndash economic policies 1 Monetary policy2 Fiscal policy3 Income policy4 Trade policy5 Industrial policy6 Import- Export policy7 Banking policy8 Planning policy

Objective of macroeconomic policy in India 1 Achieving a growth rate of 5- 6 per annum2 Creating job opportunities for unemployed amp underemployed ( not having sufficient demanding

paid work)3 Removing economic disparity ( differences)4 Eradication of poverty5 Controlling inflation amp price stabilization

5

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6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

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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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

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3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

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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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

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Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 lsquowhat it isrsquo and normative analysis is lsquowhat it should bersquo 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

Importance of the study of economics

bull The knowledge of economics helps in solving many problems

bull The knowledge of economics is essential to conquer (overcome a problem) poverty of the millions of people and to raise their standard of living

bull It explains the relationship between the producer and consumer the labour and the management

bull It gives the businessmen and industrialists the knowledge of modern methods

bull 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

bull The knowledge of economics is very essential for the finance minister

2

EEampFA Unit 1

a) It helps in framing the system of taxation

b) It helps in formulating the budget for development

c) It helps in removing unemployment

bull 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

bull The term lsquomikrosrsquo 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

bull Micro- economics is the study of particular firms particular households individual prices wages income individual industries and so on

bull 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

bull It explains how the market economy operates

bull It explains the method or manner in which scarce resources are allocated for different uses

bull It explains how goods and services are produced and distributed to the people

bull 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

bull It may not give an idea about the functioning of the whole economy

bull The results of micro economics studies may not be applicable to aggregates (total or whole)

bull It fails to give correct guidance to government to formulate economic policies

Macro economics

bull The term lsquomacrosrsquo in Greek means large Macro economics is the study of aggregates (total or whole)

bull It studies about aggregate (total) demand aggregate consumption aggregate production aggregate income and aggregate investment etc

3

EEampFA Unit 1

bull It studies all parts or components of the whole economy and it is not concerned with individual aspects of the economy

bull Macro economics examines the forest and not the trees

bull 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

bull It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic

bull It deals with many economic problems such as unemployment inflation depression (make very unhappy push down or make less active) amp recession (a temporary decline or loss in economic activity)

bull It is used as a tool to analyse the level of employment level of prices etc

bull It is useful for the government in formulating suitable economic policies regarding general price level wages etc

bull It is only through macroeconomic approach the problems of economic growth could be solved

bull All nations particularly developing nations are eager to increase their national income within the concern of macro economics

bull 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

bull Macro analysis cannot be precise because it deals with aggregates (total) which are divergent (avoiding common assumptions in making deductions) in nature

bull In aggregative (total) thinking the elements have to be chosen carefully (For eg) adding all fruits together is a meaningful aggregate Adding fruits with other machinery is an absurd (unreasonable) aggregate (ie) apple+ bike

bull 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

4

EEampFA Unit 1

bull Composition of aggregates may be imperfect in macro analysis (eg) Prices of many commodities would have fallen in the economy but the prices of very essential (necessary) commodities might have risen many times

bull 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 ldquoa programme of action undertaken to control regulate and manipulate macro economic variables to achieve the macroeconomic goals of the societyrdquo

bull Macro economics is thus a policy oriented subject It deals with a number of policies of macro nature to solve many issues amp problems

bull A macroeconomic policy is in fact an instrument of policing the economy to achieve certain economic goal

bull Macroeconomic policies have macroeconomic goals to fulfill The macroeconomic goals include 1 Price stability2 Economic stability3 Exchange rate stability4 Maintenance of full employment5 Economic growth6 Economic justice (law)7 Improvement of standard of living8 Eradication of poverty9 Equilibrium in the balance of payments10 Equitable distribution of national income (or) economic equity

There are number of macro ndash economic policies 1 Monetary policy2 Fiscal policy3 Income policy4 Trade policy5 Industrial policy6 Import- Export policy7 Banking policy8 Planning policy

Objective of macroeconomic policy in India 1 Achieving a growth rate of 5- 6 per annum2 Creating job opportunities for unemployed amp underemployed ( not having sufficient demanding

paid work)3 Removing economic disparity ( differences)4 Eradication of poverty5 Controlling inflation amp price stabilization

5

EEampFA Unit 1

6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

a) It helps in framing the system of taxation

b) It helps in formulating the budget for development

c) It helps in removing unemployment

bull 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

bull The term lsquomikrosrsquo 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

bull Micro- economics is the study of particular firms particular households individual prices wages income individual industries and so on

bull 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

bull It explains how the market economy operates

bull It explains the method or manner in which scarce resources are allocated for different uses

bull It explains how goods and services are produced and distributed to the people

bull 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

bull It may not give an idea about the functioning of the whole economy

bull The results of micro economics studies may not be applicable to aggregates (total or whole)

bull It fails to give correct guidance to government to formulate economic policies

Macro economics

bull The term lsquomacrosrsquo in Greek means large Macro economics is the study of aggregates (total or whole)

bull It studies about aggregate (total) demand aggregate consumption aggregate production aggregate income and aggregate investment etc

3

EEampFA Unit 1

bull It studies all parts or components of the whole economy and it is not concerned with individual aspects of the economy

bull Macro economics examines the forest and not the trees

bull 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

bull It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic

bull It deals with many economic problems such as unemployment inflation depression (make very unhappy push down or make less active) amp recession (a temporary decline or loss in economic activity)

bull It is used as a tool to analyse the level of employment level of prices etc

bull It is useful for the government in formulating suitable economic policies regarding general price level wages etc

bull It is only through macroeconomic approach the problems of economic growth could be solved

bull All nations particularly developing nations are eager to increase their national income within the concern of macro economics

bull 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

bull Macro analysis cannot be precise because it deals with aggregates (total) which are divergent (avoiding common assumptions in making deductions) in nature

bull In aggregative (total) thinking the elements have to be chosen carefully (For eg) adding all fruits together is a meaningful aggregate Adding fruits with other machinery is an absurd (unreasonable) aggregate (ie) apple+ bike

bull 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

4

EEampFA Unit 1

bull Composition of aggregates may be imperfect in macro analysis (eg) Prices of many commodities would have fallen in the economy but the prices of very essential (necessary) commodities might have risen many times

bull 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 ldquoa programme of action undertaken to control regulate and manipulate macro economic variables to achieve the macroeconomic goals of the societyrdquo

bull Macro economics is thus a policy oriented subject It deals with a number of policies of macro nature to solve many issues amp problems

bull A macroeconomic policy is in fact an instrument of policing the economy to achieve certain economic goal

bull Macroeconomic policies have macroeconomic goals to fulfill The macroeconomic goals include 1 Price stability2 Economic stability3 Exchange rate stability4 Maintenance of full employment5 Economic growth6 Economic justice (law)7 Improvement of standard of living8 Eradication of poverty9 Equilibrium in the balance of payments10 Equitable distribution of national income (or) economic equity

There are number of macro ndash economic policies 1 Monetary policy2 Fiscal policy3 Income policy4 Trade policy5 Industrial policy6 Import- Export policy7 Banking policy8 Planning policy

Objective of macroeconomic policy in India 1 Achieving a growth rate of 5- 6 per annum2 Creating job opportunities for unemployed amp underemployed ( not having sufficient demanding

paid work)3 Removing economic disparity ( differences)4 Eradication of poverty5 Controlling inflation amp price stabilization

5

EEampFA Unit 1

6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

bull It studies all parts or components of the whole economy and it is not concerned with individual aspects of the economy

bull Macro economics examines the forest and not the trees

bull 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

bull It is very helpful in studying the vast (huge) and complex (hard to understand) nature of economic

bull It deals with many economic problems such as unemployment inflation depression (make very unhappy push down or make less active) amp recession (a temporary decline or loss in economic activity)

bull It is used as a tool to analyse the level of employment level of prices etc

bull It is useful for the government in formulating suitable economic policies regarding general price level wages etc

bull It is only through macroeconomic approach the problems of economic growth could be solved

bull All nations particularly developing nations are eager to increase their national income within the concern of macro economics

bull 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

bull Macro analysis cannot be precise because it deals with aggregates (total) which are divergent (avoiding common assumptions in making deductions) in nature

bull In aggregative (total) thinking the elements have to be chosen carefully (For eg) adding all fruits together is a meaningful aggregate Adding fruits with other machinery is an absurd (unreasonable) aggregate (ie) apple+ bike

bull 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

4

EEampFA Unit 1

bull Composition of aggregates may be imperfect in macro analysis (eg) Prices of many commodities would have fallen in the economy but the prices of very essential (necessary) commodities might have risen many times

bull 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 ldquoa programme of action undertaken to control regulate and manipulate macro economic variables to achieve the macroeconomic goals of the societyrdquo

bull Macro economics is thus a policy oriented subject It deals with a number of policies of macro nature to solve many issues amp problems

bull A macroeconomic policy is in fact an instrument of policing the economy to achieve certain economic goal

bull Macroeconomic policies have macroeconomic goals to fulfill The macroeconomic goals include 1 Price stability2 Economic stability3 Exchange rate stability4 Maintenance of full employment5 Economic growth6 Economic justice (law)7 Improvement of standard of living8 Eradication of poverty9 Equilibrium in the balance of payments10 Equitable distribution of national income (or) economic equity

There are number of macro ndash economic policies 1 Monetary policy2 Fiscal policy3 Income policy4 Trade policy5 Industrial policy6 Import- Export policy7 Banking policy8 Planning policy

Objective of macroeconomic policy in India 1 Achieving a growth rate of 5- 6 per annum2 Creating job opportunities for unemployed amp underemployed ( not having sufficient demanding

paid work)3 Removing economic disparity ( differences)4 Eradication of poverty5 Controlling inflation amp price stabilization

5

EEampFA Unit 1

6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

bull Composition of aggregates may be imperfect in macro analysis (eg) Prices of many commodities would have fallen in the economy but the prices of very essential (necessary) commodities might have risen many times

bull 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 ldquoa programme of action undertaken to control regulate and manipulate macro economic variables to achieve the macroeconomic goals of the societyrdquo

bull Macro economics is thus a policy oriented subject It deals with a number of policies of macro nature to solve many issues amp problems

bull A macroeconomic policy is in fact an instrument of policing the economy to achieve certain economic goal

bull Macroeconomic policies have macroeconomic goals to fulfill The macroeconomic goals include 1 Price stability2 Economic stability3 Exchange rate stability4 Maintenance of full employment5 Economic growth6 Economic justice (law)7 Improvement of standard of living8 Eradication of poverty9 Equilibrium in the balance of payments10 Equitable distribution of national income (or) economic equity

There are number of macro ndash economic policies 1 Monetary policy2 Fiscal policy3 Income policy4 Trade policy5 Industrial policy6 Import- Export policy7 Banking policy8 Planning policy

Objective of macroeconomic policy in India 1 Achieving a growth rate of 5- 6 per annum2 Creating job opportunities for unemployed amp underemployed ( not having sufficient demanding

paid work)3 Removing economic disparity ( differences)4 Eradication of poverty5 Controlling inflation amp price stabilization

5

EEampFA Unit 1

6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

6 Preventing balance of payments imbalances Macro economic theories Macro ndash economic theories provide explanation to inter ndash relationship among different macro ndash economic variables amp issues relating to the problems

There are number of macro ndash economic theories1 Theory of income amp employment2 Theory of general price level3 Theory of distribution4 Theory of consumption function5 Theory of investment6 Theories of trade cycles7 Theories of economic growth8 Theories of inflation9 Theories of monetary policy10 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 lsquonational incomersquo)

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 ndash total consumption5 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

6

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 ldquoBusiness Economicsrdquo 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 EconomicsldquoManagerial Economics is economics applied in decision making It is a special branch of economics bridging the gap between abstract theory and managerial practicerdquo ndash Haynes Mote and Paul

ldquoBusiness Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by managementrdquo ndash Spencer and Seegelman

ldquoManagerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decisionrdquo ndash 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 firmrsquos 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 managerrsquos 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 Eg are profit demand cost pricing production competition business cycles

7

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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

The basic characteristics of managerial economics can now be enumerated as It is concerned with ldquodecision making of an economic naturerdquo It is ldquomicro-economicrdquo in character It largely uses that body of economic concepts and principles which is known as ldquotheory of the firmrdquo It is ldquogoal oriented and prescriptiverdquo Managerial economics is both ldquoconceptual and metricalrdquo It includes theory with measurement

Relationship of Managerial Economics with other disciplines

Managerial economics is linked with various other fields of study likendash1 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 ie 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 ldquosatisficingrdquo instead of ldquomaximisingrdquo as an objective of the enterprise Accounting data and statements constitute the language of business In fact the link is so close that ldquomanagerial accountingrdquo has developed as a separate and specialized field in itself

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 Forecasting2 Cost and Production Analysis

8

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

3 Pricing Decisions Policies and Practices4 Profit Management5 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 firmrsquos 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 profit-planning and profit measurement constitute the most challenging area of Managerial Economics

5 Capital management The problems relating to firmrsquos 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

FinanceFinancial 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 businessb) Preparation of necessary accounts and balance sheet as required by statutes andc) Appraising the owners of the business about the results of the business over a period of time

Meaning of Finance

9

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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

FINANCE FUNCTIONMONEY

MANAGEMENTRECORD

KEEPING amp REPORTING

(ACCOUNTING)

CONTROL ADVISORY ROLETechniques Systems

Resource mob i l i za t ion

Work ing Cap i ta l Management

Inves tment Management

Financ ia l Account ing

Cost Account ing

Management Account ing

Budgets Cost Cont ro l In te rna l

Aud i t

Respons ib i l i t y Cent re

Prof i t Cent re Cost Cent re Inves tment

Cent re

Pr ic ing Div idend

Po l i cy Valua t ion

Koontz and OrsquoDonell 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 lifeHuman wants are virtually unlimited and insatiable andEconomic resources to satisfy these human demands are limitedThus 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

10

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

Firms types objectives and goals

What is a firmThe 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

11

SCARCITY

What to produce

UNLIMITED CHOICE

LIMITED RESOURCES

How to produce

When to produce

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 ie 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 ndash 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 ndashmade 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 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

12

FOP (Factors of Production)

Human Resources

Labour

Entrepreneur

Capital Resources

Natural (Land)

Man-made (structures equipments and inventories)

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

of blast furnaces electric furnaces and rolling mills as well as the services of the people managing the companies

Types of Business Organisation An organizationrsquos 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 rigidmdashmaking them slow to respond to changing environments and more likely to perish in the long run

Firms are classified into different categories as followsa) Private sector firmsb) Public sector firmsc) Joint sector firmsd) Non-profit firms

Firms can also be classified on the basis of number of owners asa) Proprietorshipb) Partnershipc) 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 onlya) Universitiesb) Public Librariesc) Hospitalsd) Museumse) Churchesf) Voluntary Organisationsg) Cooperativesh) Unionsi) Professional Societies etc

Type of Business Organization ADVANTAGES DISADVANTAGESA Sole Proprietorship consists of one individual doing business Sole ProprietorshipsThe 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-to-day 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

1 Sole proprietors are 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 flow-through directly to the owners personal tax return

4 The business is easy to dissolve if desired

1 Unlimited liability 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 high-caliber employees or those that are motivated by the opportunity to own a part of the business

13

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGES6 Employee benefits such as

owners 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 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

General PartnershipPartners 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 liabilityLimited 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

1 Partnerships are relatively easy to establish however time should be invested in developing the partnership agreement

2 With more than one 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

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 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

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 Shareholders have limited liability for the corporations debts or judgments against the corporations

II Generally shareholders can only be held accountable for their investment in stock of the company (Note however that officers can be held personally liable for their actions such as the failure to withhold and pay

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

2 Corporations are monitored by federal state and some local agencies and as a result may have more paperwork to comply with regulations

3 Incorporating may result in higher overall taxes Dividends

14

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

Type of Business Organization ADVANTAGES DISADVANTAGESemployment taxes)

III Corporations can raise additional funds through the sale of stock

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

paid to shareholders are not deductible from business income thus this income can be taxed twice

OBJECTIVE OF THE FIRM

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 200000 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 20000 on buying electricity For its factory it has sacrificed claims to whatever else Rs 20000 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 profitProfit 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 transitoryThe 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 perspective15

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

iii The discounting principle

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

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 ndash R1= (Rs 4 X 1500 units) ndash (Rs 5 X 1000 units) = Rs 6000 ndash Rs 5000 = Rs 1000

MR = (6000-5000) (1500-1000) = 1000500 = 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

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 IRgtIC A decision is profitable if 1048576 it increases revenue more than it increases cost 1048576 it reduces some costs more than it increases others 1048576 it increases some resources more than it decreases others 1048576 it decreases costs more than it decreases revenues

16

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 lsquoFord Foundationrsquo 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 = PRIME COSTb) Prime cost + Factory overhead = FACTORY COSTc) Factory cost + Office amp Administrative Overhead = COST OF PRODUCTIONd) Cost of production + Opening finished stock + Closing finished stock = COST OF GOODS SOLDe) Cost of goods sold + Selling amp Distribution overheads = COST OF SALESf) Cost of sales + Profit = SALESg) Sales Quantity sold = 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 CostAns 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 10000 and the cost of producing 21 units of the same product be Rs 10045 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 15000 and the revenue of selling 21 units of the same product be Rs 15085 Then the marginal revenue of selling the 21st unit is Rs85

SUNK COST This is known as the past cost of an equipment asset Let us assume that an equipment has been purchased for Rs 100000 about three years back If it is considered for replacement then its present value is not Rs 100000 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 CostAns OPPORTUNITY COST Foregone contribution expected from the second best alternative use of resourcesThere 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

17

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 ldquoOpportunity costrdquo ie 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 lessIn 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 firmAlthough profit maximisation is a dominant objective of the firm other important objectives of the firm other than profit maximisation are1 Maximisation of sales revenue2 Maximisation of firmrsquos growth rate3 Maximisation of managerrsquos own utility or satisfaction4 Making a satisfactory rate of profit5 Long-run survival of the firm6 Entry-prevention and risk avoidance

ALTERNATIVE OBJECTIVES OF FIRMSEconomists 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 profitsBanks and financers look at sales revenue while financing the corporation The sales revenue trend is a readily available indicator of performance of the firmGrowth 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 MAXIMIZATIONMost 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 firmThe 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 Re1 10

End of the year

Time period 0 1 2 3 4

Re1 Re1 Re1 Re1

Rs 0909Rs 0826Rs 0751Rs 0683

--------18

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

Total Rs(PV) 3169=====

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 Rs3169 (discounted 10)

The compound interest rate used for discounting cash flows is called the ldquodiscount raterdquo

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 todayrsquos money

The Future Cash Flows must be recalculated (discounted) to represent their ldquopresent valuesrdquo 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 ldquorate of returnrdquo) that reflects the perceived amount of risk of the cash flows

In fact the ldquoDiscount Raterdquo reflects two things

1 The ldquoTime value of moneyrdquo Any investor would prefer to have cash immediately than having to wait Therefore investors must be compensated by paying for the delay

2 A ldquoRisk Premiumrdquo 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 Indiarsquos 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

FIRMrsquoS CONSTRAINTSDecision-making by firms takes place under several restrictions or constraints such asResource Constraints Many inputs may be available in a limited or fixed quantity eg skilled workers imported raw material etcLegal 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 examplesMoral Constraints These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviourContractual 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 firmrsquos employeesDecision-making under these constraints with optimal results is a fundamental part of managerial economics

MARGINAL UTILITY In ordinary language ldquoutilityrdquo means ldquousefulnessrdquo But in economics utility is defined as the power of a commodity

or a service to satisfy a human want19

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 apples Total Utility Marginal Utility1234567

20354550504535

20151050-5

-10

RELATIONSHIP BETWEEN TOTAL UTILITY amp MARGINAL UTIITYMARGINAL UTILITY TOTAL UTILITYDeclines

Reaches Zero

Becomes negative

Increases

Reaches maximum

Declines

20

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

THE EQUI-MARGINAL PRINCIPLE The idea of equi-marginal principle was first mentioned by HH Gossen of Germany hence it is called Gossenrsquos

Second Law The law of equi-marginal utility explains the behaviour of a consumer when he consumes more than one

commodity Consumersrsquo wants are unlimited but consumersrsquo 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

This law is also known as the ldquoLaw of substitutionrdquo or ldquoLaw of Maximum satisfactionrdquo or ldquoPrinciple of proportionality between prices and Marginal Utilityrdquo

ExplanationSuppose 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 equilibriumSymbolically the consumer will be in equilibrium when

WhereMUX = Marginal utility of commodity XPX = Price of commodity XMUY = Marginal utility of commodity YPY = Price of commodity YMUM = Marginal utility of Money

21

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

and are known as Marginal Utility of money expenditure

ldquoIf 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 allrdquo Prof MarshallThe equi-marginal principle can be applied only where

i Firms have limited investible resourcesii Resources have alternative uses and iii The investment in various alternative uses is subject

Managerial decisions

Managerial Economics (ME) serves as lsquoa link between traditional economics and the decision making sciencesrsquo 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 (eg pricing in the airline industry taking into account consumer demand profit maximization elasticity rivalsrsquo 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

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

22

MANAGERIAL ECONOMICS

Decision Problem

Decision Sciences (Tools amp

techniques of analysis)

Optimal solution to business problems

Traditional Economics

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 non-realization of objective or complete realization of objective or partial realization of objective

Decision-making Meaning and itrsquos 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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 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 for the decision problem The essential elements in a decision making process include the following

23

A C T I O N AA C T I O N BA C T I O N CD E C I S I O N M A K I N G

C H O S E N A C T I O NF u l l r e a l i s a t i o n o f o b j e c t i v e

P a r t i a l r e a l i s a t i o n o f o b j e c t i v e

N o n - r e a l i s a t i o n o f o b j e c t i v e

Alternative course of action available

Selection of a particular action

Execution of action

Result of action

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

1 The decision maker2 The decision problem3 The environment in which the decision is to be made4 The objectives of the decision maker5 The alternative courses of action6 The outcomes expected from various alternatives and7 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 action2 It is a human process involving to a great extent the application of intellectual abilities3 It is the end process preceded by deliberation and reasoning4 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 circumstances5 It involves a time dimension and a time lag6 It always has a purpose Keeping this in view there may just be a decision not to decide7 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 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 ie 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

24

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 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 ie choosing a solution that seems to be good at that time There is an inherent danger in this process because a managerrsquos intuition may be wrong on

25

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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) 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

(iii) 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 lsquoslow start gathers momentumrsquo approach may be preferable

(iv) 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 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

26

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

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 donrsquot 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 managersrsquo 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 objectives2 Specify the decision problem3 Identify the alternatives4 Evaluate alternatives5 Select the best alternatives6 Implement the decision7 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

27

EEampFA Unit 1

28

EEampFA Unit 1

28