MANAGERIAL ECONOMICS

DR H N SHIVAPRASAD

ECONOMICS

• ECONOMICS is the queen of social sciences• ECONOMICS - OIKOS+ NOMOS (Greek Words)• OIKOS (HOUSE) + NOMOS (MANAGEMENT)• It is the study of how people produce and

spend income

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What is Economics?• Economics is concerned with the allocative decisions

of individuals, Households, business & other economic agents operating in the society & how the society as a whole allocate its resources.

• Economics in the science which studies human behaviour as a relationship between ends & scarce means which have alternative uses.

• The Field of economics is divided into 2 broad fields:» Micro Economics» Macro Economics

Economics

– There are Two Branches – Micro Economics: Means ‘Small’ or ‘Individual’ . – The term ‘MICRO’ comes from the Greek word – ‘ MIKROS’ Which means ‘Small’ or ‘Individual’. – Macro Economics: Means ‘Group’ or ‘Whole’. – The term ‘MACRO’ comes from the Greek word

‘MAKROS’ Which means ‘Large’ or ‘Whole’.

Difference between Managerial Economics and Economics

Economics Managerial Economics

Comprehensive and wider scope

Narrow and limited scope

It has both Micro and Macro in nature

It is essentially Micro in nature and Macro in analysis

It is both Normative and positive science

It is mainly a Normative science

It is concerned with the formulation of theories and principles

It is concerned with the application of theories and principles of economics

It discusses general problems It discusses Individual problems

Nature of Managerial Economics

• Science as well as Art of decision making. • It is essentially Micro in nature but Macro in analysis. • It is mainly a Normative science but positive in

analysis. • It is concerned with the application of theories and

principles of economics. • It discusses Individual problems. • It is dynamic in nature not a Static. • It discuss the economic behavior of a firm. • It concentrates on optimum utilization of resources.

Chief Characteristics of Managerial Economics/Nature

– Managerial economics is micro-economic in character as it concentrates only on the study of the firm and not on the working of the economy.

– Managerial economics takes the help of macro-economics to understand and adjust to the environment in which the firm operates.

– Managerial economics is normative rather than positive in character.

– It is both conceptual (theory) and metrical (quantitative techniques).

– The contents of managerial economics are based mainly on the “theory-of firm’.

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Characteristic features of Managerial Economics

• Concerned with decision making of economic theory.• Goal oriented • Normative (what ought to be) rather than positive. (what is,

was & will be) • Micro economic in nature.• Conceptual & Metrical (help of quantitative techniques)• Allocation of resources.• Provide a link between decision science & traditional

economics.

Scope of Managerial Economics

• Objectives of a Firm. • Demand Analysis and Forecasting. • Production and cost analysis. • Pricing decisions. • Profit management. • Capital management. • Market structure. • Inflation and economic conditions.

Features of Managerial Economics:

Micro Economics oriented • There are two approaches to study of Economics.

Macro and Micro.– Macro economic approach deals with the economy as

a whole. National Income, Trade Cycles etc. are its themes.

– Micro economic approach deals with individual economic behavior.

• This is close to analysis of the decision making aspects of the unit of management at the firm level. And it provides Micro Economics orientation to Managerial Economics.

Features of Managerial Economics

Normative approach• For study of science, there is positive approach

and normative approach. – In positive approach, we are concerned with the

situation ‘as it is.’– In normative approach, we are concerned with the

situation ‘as it ought to be.’• Aim of managerial Economics is not only to

describe, but also to prescribe. Hence it has normative approach.

Positive / Normative Economics

• Positive Economics:-• Derives useful theories with testable

propositions about WHAT IS.• Normative Economics:-• Provides the basis for value judgements on

economic outcomes.WHAT SHOULD BE

Features of Managerial Economics

Only a part of the Science of Economics• Study of Economics covers issues like welfare,

money, agriculture, international trade, public finance, etc.

• Managerial Economics deals with decision taking of managerial cadre at the level of the firm .

• Thus it becomes only a part of the subject of Economics.

Features of Managerial Economics

Knowledge of Macro Economics Essential• Since firms do not work in isolation, managers

have to consider competition, government intervention, tariffs, trade & monetary policies, liberalization etc.

• This makes knowledge of macro Economics essential for a student of Managerial Economics.

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What is Managerial Economics?Douglas - “Managerial economics is .. the application of economic principles and methodologies to the decision-making process within the firm or organization.”

Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision-making.”

Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively.”

Fundamental Concepts

• Incremental Reasoning • Opportunity Cost • Contribution • Time Perspective • Time Value of Money – Discounting Principle & • Equi-Marginal Principle

Incremental Reasoning

– The firm gets an order which can get it an additional revenue of Rs. 2000. The normal cost of production of this order is:

– The addition to cost due to new order is the following

– Firm would earn a net profit of Rs 2,000 – Rs. 1400 = Rs. 600 while at first it appeared that the firm would make a loss of Rs.400 by accepting the order .

Labour Rs.600

Materials 800

Overheads 720

Selling & administration expenses

280

Full cost 2400

Labour Rs.400Materials 800Overheads 200Full cost Rs.1400

Incremental Reasoning

A course of action should be pursued up to the point where its incremental benefits equal its incremental costs.

Opportunity Cost Principle

• Choice involves sacrifice. • The cost involved with the sacrifice • It is the cost of an next best opportunity which is

lost will be called as Opportunity cost. • Ex: 100 Rs can be used for purchasing book or

eating in pizza corner or purchasing of stationeries.

• Now the cost of purchasing book is also include the cost of ‘Eating pizza.’

Opportunity Cost

Opportunity cost, therefore, represents the benefits of revenue forgone by pursuing one course of action rather than another.

– For e.g: – (a) The opportunity cost of the funds employed in

one’s own business is the amount of interest which could have been earned had these funds been invested in the next best channel of investment

– (b) The opportunity cost of using an idle machine is zero, as its use needs no sacrifice of opportunities.

Opportunity Cost

–Opportunity cost includes both the explicit and implicit costs:- – Explicit costs are recognized in the

accounts , e.g., the payments for labour, raw materials, etc – Implicit (or imputed) costs are sacrifices

that are not recorded in accounting e.g. cost of capital supplied by owners of business.

Time Perspective

Economists often make a distinction between short run and long run.

– Short run means that period within which some of the inputs (called fixed inputs) cannot be altered.

– Long run means that all the inputs can be changed.

– In short run change in the output can be achieved by changing the intensity of use of the fixed inputs.

– In the long run change in the output can be achieved by adjusting the scale of output, size of the firm, etc…

– Economists try to study the effect of policy decisions on variables like prices, costs, revenue, etc, in the light of these time distinctions.

Discounting Principle

• The concept of discounting future is based on the fundamental fact that a rupee now is worth more than a rupee earned a year after.

• The concept of discounting future is based on the fundamental fact that, a rupee earned now is worth more than the a rupee earned a year after, even if there will be a certain future return, yet it must be discounted because to wait for future implies a sacrifice for the present.

• Unless these returns are discounted to find their present worth, it is not possible to judge whether or not it is worth undertaking the investment today.

Discounting Principle

• Let a sum of Rs 100 is due after 1 year; rate of interest is 10%; Then we can determine the sum to be invested so as to produce the return ® of Rs 100 at the end of 1 year.

• The present value or the discounted value of Rs 100 will be,

– V = R/ (1 + i) = 90.90

The Equi-Marginal Principle

The law of equi-marginal utility states that a utility maximizing consumer distributes his consumption expenditure between various goods and services he/she consumes in such a way that the marginal utility derived from each unit of expenditure on various goods and service is the same.

– This principle suggests that available resources (inputs) should be so allocated between the alternative options that the marginal productivity (MP) from the various activities are equalized.

– For eg. Suppose a firm has a total capital of Rs. 100 million which it has the option of spending on three projects, A,B, and C. Each of these projects requires a unit expenditure of Rs. 10 million.

The Equi-Marginal Principle• The equi-marginal principle suggests that a

profit maximizing firm allocates its resources in proportions such that:

MPA = MPB = MPC = …….+ MPN

• The equi-marginal principle can only be applied where:

I. firms have limited investible resourcesII. resources have alternative uses and III. the investment in various alternative uses is subject

to diminishing marginal utility