Managerial Economics Lecture notes

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? Managerial Economics NATURE AND SCOPE OF ECONOMIC ANALYSIS Structure 1.1 Introduction to Economics 1.2 Concept of Economics in Decision Making 1.3 Scope of Managerial Economics 1.4 Relationship between Managerial Economics and Other Subjects 1.5Tools and Techniques of Decision Making 1.6 Review Questions 1.1 INTRODUCTION TO ECONOMICS This unit introduces you to the basic concepts of Economics. After going through this unit you will come to know how Economics is helpful for Managers in their Decision making process. Objectives: • To analyze the concept of economics- scarcity and efficiency • Micro Economics and macro economics • Concept of managerial economics • How managerial economics differ from economics and its relationship with management Good morning students, the basic purpose of our studying of economics are the efficient utilization of scarce resources. We always have to make choices amongst various alternatives available for efficient utilization of our scarce resources. The twin theme of economics is scarcity and efficiency. We will discuss this twin theme in detail before coming to managerial economics. Scarcity and Efficiency: The first question which comes here is what is Economics? Economics is the study of how society chooses to use productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. Two key ideas in economics: • Scarcity of goods 5• Efficient use of resources ™ Scarcity of goods The word scarce is closely associated with the word limited or economic as opposed to unlimited or free. Scarcity is the central problem of every society. • Concept lies at the problem of resource allocation and problem of a business enterprise. • The essence of any economic problem, micro or macro, is the scarcity of resources. • The managers who decide on behalf of the corporate unit or the national economy always face the economic problem of Scarcity of good quality of materials or skilled technicians As a Marketing Manager: He may be encountering scarcity of sales force at his command As a Finance Manager: He may be facing the scarcity of funds necessary for expansion or renovate a program As a Finance Minister of the Country: His basic problem when he prepares the budget every year is to find out enough revenue resources to finance the necessary expenditure on plans and programs. Thus, we see that Scarcity is a universal phenomenon. Let us attempt a technical definition of “Scarcity” • In economic terms it can be termed as “ Excess of Demand” • Any time for any thing if its demand exceeds its supply, that thing is said to be scarce. • Scarcity is a relative term: Demand in relation to its supply determines the element of scarcity. Problem: Unemployment: Scarcity of jobs Unsold stock of inventory: Scarcity of buyers Under utilized capacity of plan: Scarcity of power or other support facilities. Had there been no scarcities there would not have been any managerial problem. It is only because of this scarcity a manager has to decide on optimum allocation of scarce resources of: • Man • Materials • Money • Time • Energy Thus we see that every business unit or manager must aim at rational but optimum allocation of scarce resources. Optimality lies in finding the best use of scarce resources, given to the constraints. 6™ Efficiency of Resources Economy makes best use of its limited resources. That brings the critical notion of efficiency. Efficiency denotes most effective use of a society’s resources in satisfying people’s wants and needs. Consider the Monopoly Situation: In economics we say that an economy is producing efficiently when it cannot make anyone economically better off without making someone else worse off. The essence of economics is to acknowledge the reality of scarcity and then figure out how to organize society in such a way, which produces the most efficient use of resources. Economics can be called as social science dealing with economics problem and man’s economic behavior. It deals with economic behavior of man in society in respect of consumption, production; distribution etc. Economics can be called as an unending science. There are almost as many definitions of economy as there are economists. We know that definition of subject is to be expected but at this stage it is more useful to set out few examples of the sort of issues which concerns professional economists. Example: For e.g. most of us want to lead an exciting life i.e. life full of excitements, adventures etc. but unluckily we do not always have the resources necessary to do everything we want to do. Therefore choices have to be made or in the words of economists “individuals have to decide “how to allocate scarce resources in the most effective ways”. For this a body of economic principles and concepts has been developed to explain how people and also business react in this situation. Economics provide optimum utilization of scarce resources to achieve the desired result. It provides the basis for decision making. Economics can be studied under two heads: 1. Micro Economics 2. Macro Economics Micro Economics: It has been defined as that branch where the unit of study is an individual, firm or household. It studies how individual make their choices about what to produce, how to produce, and for whom to produce, and what price to charge. It is also known as the price theory and is the main source of concepts and analytical tools for managerial decision making. Various micro-economic concepts such as demand, supply, elasticity of demand and supply, marginal cost, various market forms, etc. are of great significance to managerial economics. Macro Economics: It’s not only individuals and forms that are faced with having to make choices. Governments face many such problems. For e.g. How much to spend on health; How much to spend on services; How much should go in to providing social security benefits. This is the same type of problem faced by all of us in our daily lives but in different scales. It studies the economics as a whole. It is aggregative in character and takes the entire economy as a unit of study. Macro economics helps in the area of forecasting. It includes National Income, aggregate consumption, investments, employment etc. 7Following are the various economic concepts which are useful for managers for decision making: • Price elasticity of demand • Income elasticity of demand • Cost and output relationship • Opportunity cost • Multiplier • Propensity to consume • Marginal revenue product • Production function • Demand theory • Theory of firm: price, output and investment decisions • Money and banking • Public finance and fiscal and monetary policy • National income • Theory of international trade The Three Problems of Economic Organization: Because of scarcity, all economic choices can be summarized in big questions about the goods and services a society should produce. These questions are: • What to produce? • How to produce? • For whom to produce? What to Produce? The first question every society faces is what to produce. Should a society build more roads or schools? Because of scarcity, society can not build everything it wants. Choices have to be made. Once a society determines what to produce it then needs to decide how much should be produced. In a market economy the "what" question is answered in large part by the demand of consumers? How to Produce? The next question a society needs to decide after what to produce is how to produce the desired goods and services. Each society must combine available technology with scarce resources to produce desired goods and services. The education and skill levels of the citizens of a society will determine what methods can be used to produce goods and services. For example, does a nation possess the technology and skills to pick grapes with a mechanized harvester, or does it have to pick the grapes by hand? For whom to produce? The final question each society needs to ask is for whom to produce. Who is to receive and consume the goods and services produced? Some workers have higher incomes than others. This means more goods and services in a society will be consumed by these wealthy individuals, and less by the poor. Different groups will benefit from the different ways that we choose to spend our money. 8Inputs and Outputs: Every economy must make choices about the economy’s inputs and outputs. Inputs: Commodities used to produce goods and services .A economy uses its existing technology to combine inputs to produce outputs. Output: The various useful goods and services that result from production process that is directly consumed or employs in further production. Another term for inputs is factors of production: Factors of Production: It refers to the resources used to produce goods and services in a society. Economists divide these resources into the four categories described below. • Land refers to all natural resources. Such things as the physical land itself, water, soil, timber are all examples of land. The economic return on land is called rent. For example, a person could own land and rent it to a farmer who could use it to grow crops. A second resource is labor. • Labor refers to the human effort to produce goods and services. The economic return on labor is called wages. Anyone who has worked for a business and collected a paycheck for the work done understands wages. A third factor of production is capital. • Capital is anything that is produced in order to increase productivity in the future. Tools, machines and factories can be used to produce other goods. The field of economics differs from the field of finance and does not consider money to be capital. The economic return on capital is called interest. • Finally, the fourth factor of production is called entrepreneurship. Entrepreneurship refers to the management skills, or the personal initiative used to combine resources in productive ways. Entrepreneurship involves the taking of risks. The economic return on entrepreneurship is profits Meaning of Managerial Economics: It is another branch in the science of economics. Sometimes it is interchangeably used with business economics. Managerial economics is concerned with decision making at the level of firm. It has been described as an economics applied to decision making. It is viewed as a special branch of economics bridging the gap between pure economic theory and managerial practices. It is defined as application of economic theory and methodology to decision making process by the management of the business firms. In it, economic theories and concepts are used to solve practical business problem. It lies on the borderline of economic and management. It helps in decision making under uncertainty and improves effectiveness of the organization. The basic purpose of managerial economic is to show how economic analysis can be used in formulating business plans. Definitions of Managerial Economics: In the words of Mc Nair and Merriam,” ME consist of use of economic modes of thought to analyze business situation”. According to Spencer and Seigelman it is defined as the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management”. Economic provides optimum utilization of scarce resource to achieve the 9desired result. ME’s purpose is to show how economic analysis can be used formulating business planning. Managerial Economics = Management + Economics Management deals with principles which helps in decision making under uncertainty and improves effectiveness of the organization. On the other hand economics provide a set of preposition for optimum allocation of scarce resources to achieve a desired result. Managerial Economics deals with the integration of economic theory with business practices for the purpose of facilitating decision making and forward planning by management. In other words it is concerned with using of logic of economics, mathematics, and statistics to provide effective ways of thinking about business decision 1.2 CONCEPT OF ECONOMICS IN DECISION MAKING Students, earlier we had discussed various aspects of economics- scarcity and efficiency and meaning and role of managerial economics. Now we will be discussing the various aspects of decision making. What do you mean by Decision Making? Well decision making is not something which is related to managers only or which is related to corporate world, but it is something which is related to everybody’s life. Whether a person is working or non working, irrespective of his/her field, decision making is important to everyone. You need to make decision irrespective of the work you are doing. As a student also you have to take so many decisions. Suppose at a particular point of time you want to go for a movie, and at the same point of you want to go for shopping then what you will do. You can’t do two things at the same point of time. You have to decide what to do first and what to do next. Therefore decision making can be called as choosing the right option from the given one. To decide is to choose. Whether to do this or to do that is what is decision making. Decision making is the most important function of business managers. Decision making is the central objective of Managerial Economics. Decision making may be defined as the process of selecting the suitable action from among several alternative courses of action. The problem of decision making arises whenever a number of alternatives are available. Such as: • What should be the price of the product? • What should be the size of the plant to be installed? • How many workers should be employed? • What kind of training should be imparted to them? • What is the optimal level of inventories of finished products, raw material, spare parts, etc.? Therefore we can say that the problem of decision making arises due to the scarcity of resources. We have unlimited wants and the means to satisfy those wants are limited, with the satisfaction of one want, another arises, and here arises the problem of decision 10making. While performing his function manager has to take a lot of decisions in conformity with the goal of the firm. Most of the decisions are taken under the condition of uncertainty, and involves risks. The main reasons behind uncertainty and risks are uncertain behavior of the market forces which are as follows: • The demand and supply • Changing business environment • Government policies • External influence on the domestic market • Social and political changes • The maximum use of limited resources. Now we will discuss various aspects relating to the management decision making or Managerial Decision Making. • What Is Management? 9 Management is the process of coordinating people and other resources to achieve the goals of the organization 9 .Most organizations use various kinds of resources. • Basic Management Functions A number of management functions must be performed if any organization is to succeed. 9 Establishing Goals and Objectives. 9 Establishing Plans to Accomplish Goals and Objectives. 9 Organizing the Enterprise. Leading and Motivating 9 Controlling Ongoing Activities. • Kinds of Managers They can be classified along two dimensions: 9 Level within the organization which include: Top managers; Middle Managers; First Line Managers. 9 Area of management which include: Financial Managers; Operations Managers; Marketing Managers; Human Resources Managers; Administrative Managers. • What Makes Effective Managers? Key Management Skills. The skills that typify effective managers tend to fall into three categories. 9 Technical Skills 9 Conceptual Skills. 9 Interpersonal Skills. 9 Managerial Roles. 9 Decisional Roles 9 Interpersonal Roles 9 Informational Roles. 11 • Managerial Decision Making Decision-making is the act of choosing one alternative from among a set of alternatives. Managerial decision making involves four steps. 9 Identifying the Problem or Opportunity 9 Generating Alternatives. 9 Selecting an Alternative 9 Implementing and Evaluating the Solution Now we will discuss the various factors affecting decision making. • Conditions Affecting Decision Making: An Ideal Business situation would be the one where 9 Full Information with managers to make decisions with certainty 9 An Actual business situation with managers: 9 Most business are characterized by incomplete or ambiguous information • Conditions that affect decision making: (certainty, risk and uncertainty) 9 Certainty: Situation when decision makers are fully informed about A problem; Alternative solutions; their respective outcomes; Individuals can anticipate, and even exercise some control over events and their outcomes. 9 Risk: Condition when decision makers rely on incomplete, yet reliable information. Manager does not know the certainty the future outcomes associated with alternative courses of action, although he knows the probability associated with each alternative 9 Uncertainty: It is the condition that exists when little or no factual information is available about a problem, its alternative and their respective outcomes. He does not have enough information to determine the probabilities associated with each alternative possible that he may be unable even to define the problem Hope you all must be clear with the concepts certainty, risk and uncertainty. Now, we will discuss various models of decision making. ™ Decision Making Models • The Classical Model: 9 Also called rational model 9 A prescriptive approach that outlines how managers should make decisions. 9 Assumptions: Manager has complete information about decision situation and operations under condition of certainty; Problem is clearly defined, and the decision – maker has knowledge of all possible alternatives and their outcomes; Through the use of quantitative techniques , rationality and logic , 12the decision maker evaluates the alternatives and selects the optimum alternative . • The Administrative Model 9 Descriptive approach that outlines how managers actually do make decisions 9 Also called organizational, neoclassical or behavioral model 9 Simon recognized that people do not always make decisions with logic and rationality , he introduced two concepts- bounded rationality and satisfying Bounded rationality: Means people have limits, or boundaries , to their rationality boundaries exist because people are bound by their own values and skills, incomplete information, own inability due to time , resource and rational decisions lack of time to process complete information about complex decisions , wind up having to make decisions with only partial knowledge about alternative solutions and their outcomes. This leads manager often for go the various steps of decision making in favor of a quicker yet satisfying, process satisfying 9 Assumptions: Manager has incomplete information and operate under condition of risk or uncertainty; Problem not clearly defined, manager has limited knowledge of possible alternatives and their outcomes; Satisfies by choosing the first satisfactory alternative – one that will resolve the problem situation by offering a good solution to the problem Managerial economics is concerned with decision making at the firm level. Decision making problems faced by business firms: • To identify the alternative courses of action of achieving given objectives. • To select the course of action that achieves the objectives in the economically most efficient way. • To implement the selected course of action in a right way to achieve the business objectives. The prime function of management is Decision making and forward planning. Forward planning goes hand in hand with decision making. Forward planning means establishing plans for the future. 1.3 SCOPE OF MANAGERIAL ECONOMICS Can you tell me what you mean by the scope of the managerial economics? Well scope is something which tells us how far a particular subject will go. As far as Managerial Economic is concerned it is very wide in scope. It takes into account almost all the problems and areas of manager and the firm. Managerial economics deals with Demand analysis, Forecasting, Production function, Cost analysis, Inventory Management, Advertising, Pricing System, Resource allocation etc. Following aspects are to be taken into account while knowing the scope of managerial economics: 13• Demand Analysis and Forecasting: Unless and until knowing the demand for a product how can we think of producing that product. Therefore demand analysis is something which is necessary for the production function to happen. Demand analysis helps in analyzing the various types of demand which enables the manager to arrive at reasonable estimates of demand for product of his company. Managers not only assess the current demand but he has to take into account the future demand also. • Production Function: Conversion of inputs into outputs is known as production function. With limited resources we have to make the alternative use of this limited resource. Factor of production called as inputs is combined in a particular way to get the maximum output. When the price of input rises the firm is forced to work out a combination of inputs to ensure the least cost combination. • Cost analysis: Cost analysis is helpful in understanding the cost of a particular product. It takes into account all the costs incurred while producing a particular product. Under cost analysis we will take into account determinants of costs, method of estimating costs, the relationship between cost and output, the forecast of the cost, profit, these terms are very vital to any firm or business. • Inventory Management: What do you mean by the term inventory? Well the actual meaning of the term inventory is stock. It refers to stock of raw materials which a firm keeps. Now here the question arises how much of the inventory is ideal stock. Both the high inventory and low inventory is not good for the firm. Managerial economics will use such methods as ABC Analysis, simple simulation exercises, and some mathematical models, to minimize inventory cost. It also helps in inventory controlling. • Advertising: Advertising is a promotional activity. In advertising while the copy, illustrations, etc., are the responsibility of those who get it ready for the press, the problem of cost, the methods of determining the total advertisement costs and budget, the measuring of the economic effects of advertising are the problems of the manager. There’s a vast difference between producing a product and marketing it. It is through advertising only that the message about the product should reach the consumer before he thinks to buy it. Advertising forms the integral part of decision making and forward planning. • Pricing system: Here pricing refers to the pricing of a product. As you all know that pricing system as a concept was developed by economics and it is widely used in managerial economics. Pricing is also one of the central functions of an enterprise. While pricing commodity the cost of production has to be taken into account, but a complete knowledge of the price system is quite essential to determine the price. It is also important to understand how product has to be priced under different kinds of competition, for different markets. Pricing equals cost plus pricing and the policies of the enterprise. Now it is clear that the price system touches the several aspects of managerial economics and helps managers to take valid and profitable decisions. • Resource allocation: Resources are allocated according to the needs only to achieve the level of optimization. As we all know that we have scarce resources, and unlimited needs. We have to make the alternate use of the available resources. 14For the allocation of the resources various advanced tools such as linear programming are used to arrive at the best course of action. Nature of Managerial Economics: Managerial economics aims at providing help in decision making by firms. It is heavily dependent on microeconomic theory. The various concepts of micro economics used frequently in managerial economics include Elasticity of demand; Marginal cost; Marginal revenue and Market structures and their significance in pricing policies. Macro economy is used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. It is the level of national income only that the level of various products depends. In managerial economics macro economics indicates the relationship between (a) the magnitude of investment and the level of national income, (b) the level of national income and the level of employment, (c) the level of consumption and the level of national income. In managerial economics emphasis is laid on those prepositions which are likely to be useful to management. 1.4 RELATIONSHIP BETWEEN MANAGERIAL ECONOMICS AND OTHER SUBJECTS After studying the above you will be able to distinguish managerial economics with its related subjects. Managerial economic is not something which is related to economics only, but there are other areas also to which managerial economic is related. Other related subjects of managerial economics are: • Economics • Mathematics • Statistics • Accounting • Operation Research • Computers • Management Before knowing the relationship between managerial economics and other related fields it is customary to divide economics into “positive” and “normative” economics. Economists make a distinction between positive and normative that closely parallels popper’s line of demarcation. Positive Economics: It deals with description and explanation of economic behavior, Economics and Managerial economics. Managerial economics draws on positive economics by utilizing the relevant theories as a basis for prescribing choices. A positive statement is a statement about what is and which contains no indication of approval or disapproval. It’s not like that positive statement is always right, positive statement can be wrong. Positive statement is a statement about what exists. Normative Economics: It is concerned with prescription or what ought to be done. In normative economics, it is inevitable that value judgment are made as to what should and 15what should not be done. Managerial economics is a part of normative economics as its focus is more on prescribing choice and action and less on explaining what has happened. It expresses a judgment about whether a situation is desirable or undesirable. The primary task of Managerial economics is to fit relevant data to this framework of logical analysis so as to reach valid conclusion as a basis for action. Another branch of economics which is normative like managerial is public policies analysis which is concerned with the problems of managing the government of a country. Economic and Managerial Economics: Economics contributes a great deal towards the performance of managerial duties and responsibilities. Just as the biology contributes to the medical profession and physics to engineering, economics contributes to the managerial profession. All other qualifications being same, managers with working knowledge of economics can perform their function more efficiently than those without it. What is the Basic Function of the Managers of the Business? As you all know that the basic function of the manager of the firm is to achieve the organizational objectives to the maximum possible extent with the limited resources placed at their disposal. Economics contributes a lot to the managerial economics. Mathematics and Managerial Economics: Mathematics in Managerial Economics has an important role to play. Businessmen deal primarily with concepts that are essentially quantitative in nature e.g. demand, price, cost, wages etc. The use of mathematical logic in the analysis of economic variable provides not only clarity of concepts but also a logical and systematical framework. Statistics and Managerial Economics: Statistical tools are a great aid in business decision making. Statistical techniques are used in collecting processing and analyzing business data, testing and validity of economics laws with the real economic phenomenon before they are applied to business analysis. The statistical tools for e.g. theory of probability, forecasting techniques, and regression analysis help the decision makers in predicting the future course of economic events and probable outcome of their business decision. Statistics is important to managerial economics in several ways. Managerial Economics calls for marshalling of quantitative data and reaching useful measures of appropriate relationship involves in decision making. Let me explain it through an example: In order to base its price decision on demand and cost consideration, a firm should have statistically derived or calculated demand and cost function. Operation Research and Managerial Economics: It’s an inter-disciplinary solution finding techniques. It combines economics, mathematics, and statistics to build models for solving specific business problems. Linear programming and goal programming are two widely used Operational Research in business decision making. It has influenced Managerial Economics through its new concepts and model for dealing with risks. Though economic theory has always recognized these factors to decision making in the real world, the frame work for taking them into account in the context of actual problem has been operationalized. The significant relationship between Managerial Economics 16and Operational Research can be highlighted with reference to certain important problems of Managerial Economics which are solved with the help of Operational Research techniques, like allocation problem, competitive problem, waiting line problem, and inventory problem. Management Theory and Managerial Economics: As the definition of management says that it’s an art of getting things done through others. Bet now a day we can define management as doing right things, at the right time, with the help of right people so that organizational goals can be achieved. Management theory helps a lot in making decisions. ME has also been influenced by the developments in the management theory. The central concept in the theory of firm in micro economic is the maximization of profits. ME should take note of changes concepts of managerial principles, concepts, and changing view of enterprises goals. Accounting and Managerial Economics: There exits a very close link between Managerial Economics and the concepts and practices of accounting. Accounting data and statement constitute the language of business. Gone are the days when accounting was treated as just bookkeeping. Now it’s far more behind bookkeeping. Cost and revenue information and their classification are influenced considerably by the accounting profession. As a student of MBA you should be familiar with generation, interpretation, and use of accounting data. The focus of accounting within the enterprise is fast changing from the concept of bookkeeping to that of managerial decision making. Mathematics is closely related to Managerial Economics, certain mathematical tools such as logarithm and exponential, vectors, determinants and matrix algebra and calculus etc. Computers and Managerial Economics: You all know that today’s age is known as computer age. Every one of us is totally dependent on computers. These computers have affected each one of us in every field. Managers also have to depend on computers for decision making. Computer helps a lot in decision making. Through computers data which are presented in such a nice manner that it’s really very easy to take decisions. There are so many sites which help us in giving knowledge of various things, and in a way helps us in updating our knowledge. Conclusions: Managerial Economics is closely related to various subjects i.e. Economics, mathematics, statistics, and accountings. Computers etc. a trained managerial economist integrates concepts and methods from all these subjects bringing them to bear on business problem of a firm. In particular all these subjects are getting closed to Managerial Economics and there appears to be trends towards their integration. 1.5 TOOLS AND TECHNIQUES IN DECISION MAKING After understanding the above you now will be able to know the various tools and techniques of decision making. How these tools and technique are useful for managers in making the right decision. But before knowing the tools and technique of decision making can you answer some of my questions: • Is decision making a process? 17• Are there any particular steps required for decision making? • Is decision making depends on the condition or situations? • What are the various conditions affecting decision making? Factors Influencing Managerial Decision: Now it’s clear that managerial decision making is influenced not only by economics but also by several other significant considerations. While economic analysis contributes a great deal to problem solving in an enterprise it is important to remember that three other variables also influences the choices and decision made by the managers. These are as follows: • Human and behavioral considerations • Technological forces • Environmental factors. Steps in Decision Making: There are certain things which are to be taken into account while making decisions. No matter what’s the size of the problem but like every thing decision making should also be in certain steps. Following are the various steps in decision making: • Establish objectives • Specify the decision problem • Identify the alternatives • Evaluate alternatives • Select the best alternatives • Implement the decision • Monitor the performance Business decision making is essentially a process of selecting the best out of alternative opportunities open to the firm. The above steps put manager’s analytical ability to test and determine the appropriateness and validity of decisions in the modern business world. Modern business conditions are changing so fast and becoming so competitive and complex that personal business sense, intuition and experience alone are not sufficient to make appropriate business decisions. It is in this area of decision making that economic theories and tools of economic analysis contribute a great deal. Basic Economic Tools in Managerial economics for Decision Making: Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These tools are helpful for managers in solving their business related problems. These tools are taken as guide in making decision. Following are the basic economic tools for decision making: • Opportunity cost principle; • Incremental principle; • Principle of the time perspective; • Discounting principle; • Equimarginal principle. 18Opportunity Cost Principle: OC of a decision is the sacrifice of alternatives required by that decision; OC represents the benefits or revenue forgone by pursuing one course of action rather than another; OC are not recorded in the accounting records of the firm, but have to be met if the firm aims at optimization. OC is always higher to Accounting Costs When ever a manager takes or makes a decision, he chooses one course of action, sacrificing the other alternatives. We can evaluate the one chosen in terms of the other (next best) which is sacrificed. All decisions which involve choice must involve opportunity cost principle. OC may be either real or monetary, either implicit or explicit, either non-quantifiable or quantifiable. Decisions involving opportunity cost includes; Make or buy; Breakdown or preventive maintenance of machines; Replacement or new investment decision; direct recruitment from outside or Departmental promotion. Accountant never considers opportunity cost, he considers only explicit costs .Accounting Profit = revenue-recorded costs. Economic profit=revenue – (explicit +implicit costs) i.e. Economic profit= Accounting profit-opportunity costs. For optimal allocation of scarce resources the manager should consider the opportunity costs of using resources, human or non-human, in a given activity; Decision principle should be minimization of opportunity costs, given objectives and constraints. By the opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. For e.g. • The opportunity cost of the funds employed in one’s own business is the interest that could be earned on those funds if they have been employed in other ventures. • The opportunity cost of using a machine to produce one product is the earnings forgone which would have been possible from other products. • The opportunity cost of holding Rs. 1000as cash in hand for one year is the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in bank. It’s clear now that opportunity cost requires ascertainment of sacrifices. If a decision involves no sacrifices, its opportunity cost is nil. For decision making opportunity costs are the only relevant costs. Incremental Principle: It is related to the marginal cost and marginal revenues, for economic theory. Incremental concept involves estimating the impact of decision alternatives on costs and revenue, emphasizing the changes in total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decisions. The two basic components of incremental reasoning are • Incremental cost • Incremental Revenue The incremental principle may be stated as under: “A decision is obviously a profitable one if: • It increases revenue more than costs • It decreases some costs to a greater extent than it increases others • It increases some revenues more than it decreases others and • It reduces cost more than revenues” 19Principle of Time Perspective: Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations. Decision making is the task of co-coordinating along the time scale- past, present and future. Whenever a manager confronts a decision environment, he must analyze the present problem with reference to the past data of facts, figures and observation in order to arrive at a decision, contemplating clearly its future implications in terms of actions and reactions likely thereupon. Thus, time dimension is very important. Economist consider time in terms of concepts like: Temporary run: the supply of output ; Fixed short run: supply can be changed slightly by altering the factor proportion( all factors are not variable) Long run: All factors are variables , output level can be adjusted freely. There exist constraints in temporary and short run, but none in long run for a manager, Short run is the (present) period and long run is the future (remote) period. Manager must calculate the opportunity cost if they have to choose between the present and future. His decision principle must take care of both time periods. He can not afford to have a time period which is too short Example: • He may set a high price for his product today but then he should be prepared to face the declining sales • Today the advertisement cost might inflate the prices but tomorrow it may increase the revenue flow. • Management may ignore labor welfare today to reduce costs but in future this may deteriorate industrial relation climate with adverse effect on productivity and profitability It is important for a manager to take a short and a long view of his decision. For example, suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to management’s attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the whole lot but not more. The short run incremental cost (ignoring the fixed cost) is only Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the lot) Analysis: From the above example the following long run repercussion of the order is to be taken into account: If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contribution. If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against. In the above example it is therefore important to give due consideration to the time perspectives. “a decision should take into account both the short run and long run effects on revenues and costs and maintain the right balance between long run and short run perspective”. Discounting Principle: Discounting is both a concept as well as technique borrowed from accountancy. For explanation readopt the opportunity and time perspective. Consider the case of the seller. The seller has to decide between the immediate cash payment of Rs. 1000 by his customer and the future payment of say Rs. 1100 at the end of one year from now. 20• Human nature is such that there is time preference for present • For the seller it is better to get Rs 1000 now and keep it in bank at 10 % rate of interest and realize Rs 1100 thereby. • Should we say that the present value of future sum of Rs.1100 is just Rs. 1000? • How have we arrived at this? • A = P+ rP , or P= A /(1+r) 1 1 2 • Second Year , P= A /(1+r) 2 • If an investment of a sum yields a series of return A through i period; i=1n , then i in order to calculate its present value, we need to discount ∑ A with the help of I I I (1+r) P =∑ A / (1+r) i I • Longer the period, larger the discount factor, (1+r) exceeds. Heavy discounting for the distant period makes sense because future is uncertain; distant future involves incalculable risk. • Discounting enables risk hedging, particularly in context of investment decisions where the return on investment is spread over a number of years in future • Present value of future return can be estimated by discounting it with the opportunity costs of the safe rate of interest. • Principle also has applications other than investments wages are equal to the discounted value of the marginal productivity of labor” Thus one of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Marginal Principle: Due to scarce resources at the disposable, the manager has to be careful of spending each and every additional unit of resources. In order to decide whether to use an additional man hour or machine hour or not you need to know the additional output expected from there. A decision about additional investment has to be viewed in terms of additional returns from the investment. Economists use the word “Marginal” for additional magnitudes of production or return. Economist often use the terms like • Marginal output of labor • Marginal output of machine • Marginal return on investment • Marginal revenue of output sold • Marginal cost of production • Marginal utility of consumption 1.6 REVIEW QUESTIONS 1. What is the meaning of managerial economics? 2. What do you mean by decision Making 3. Explain the Nature and Scope of Managerial Economics. 4. Give the relation between Managerial economics and other fields of study. 5. Give a detailed account on the tools and techniques of decision making. 21 DEMAND AND ITS ATTRIBUTES Structure 2.1 Demand and its Determinants 2.1.1 Significance of Demand Analysis 2.1.2 Concept of Demand 2.1.3 Demand Function and Demand Curve 2.1.4 Types of Demand 2.2 Law of Demand 2.2.1 Characteristics of Law of Demand 2.2.2 Exceptions of Law of Demand 2.3 Utility Approaches to the Theory of Demand 2.4 Consumer Equilibrium and Demand Curve 2.5 Demand Elasticities and Demand Estimates 2.5.1 Calculating Elasticity Coefficients 2.5.2 Types of Elasticities 2.5.3 Determinants of Elasticity 2.5.4 Managerial Uses of Elasticity Concepts 2.6 Aggregate Demand 2.7 Demand Forecasting 2.7.1 Concepts of Forecasting 2.7.2 Need for Demand Forecasting 2.7.3 Steps in Demand Forecasting 2.7.4 Techniques of Demand Forecasting 2.7.5 Complex Statistical Methods 2.8 Review Questions 2.1 DEMAND AND ITS DETERMINANTS Students why have you selected M.B.A. in your career? It is because M.B.A.’s have great demand in a job market. Thus demand is one of the most critical economic decision variables. Demand reflects the size and the pattern of market. Business activity is always 22market-determined. The manufacturers inducement to invest in a given line of production is limited by the size of market. The demand for output and input; the demand for the firm and the industry; the demand by the consumer and stockiest; and similar other demand concepts become therefore, relevant for managerial decision analysis. Even if the firm pursues objectives alternative to profit-maximization, demand concepts still remain relevant. For example, suppose the firm is aiming at ‘customer service’ not profit. How can it ensure quantity and quality of service, without analyzing what the customer really wants? Suppose, the firm is destined to discharge ‘social responsibility’ of business. Can this be done without evaluating social preferences? Tastes, preferences and choices are all concepts directly built into the economic concepts of ‘demand’. 2.1.1 Significance of Demand Analysis • Demand is one of the crucial requirements for the functioning of any business enterprise its survival and growth. • Demand analysis is of profound significance to management. Information on the size and type of demand helps management in planning its requirements of men, materials, machines, money and what have you. For example, if the demand for a product is subject to temporary business recession, the firm may plan to pile up the stock of unsold products. If the demand for a product shows a trend towards a substantial and sustained increase in the long run, the firm may plan to install additional plant and equipment to meet the demand on a permanent basis. If the demand for a firm’s product is falling, while its rival’s sale is increasing, the firm needs to plan its sales tactics; the firm may need to undertake some sales promotion activity like advertisement. If the firm’s supply of the product is unable to meet its existing demand, the firm may be required to revise its production plan and schedule; or the firm may have to review its purchase plan for inputs and the suppliers’ response to input requirements by the firm. In the same way, larger the demand for a firm’s product, the higher is the price the firm can change. The common theme underlying these examples is that the whole range of planning by the firm: production planning, inventory planning, cost budgeting, purchase plan, market research, pricing decision, advertisement budget, and profit plan etc. call for an analysis of demand. In fact, demand analysis is one area of economics that has been used most extensively by business. The decision which management makes with respect to any functional area, always hinges on an analysis of demand. Demand analysis seeks to identify and measure the forces that determine sales; it reflects the market conditions for the firm’s product. Once the demand analysis is done, the alternative ways of creating, controlling or managing demand can be inferred. 2.1.2 Concept of Demand As we have indicated earlier, ‘demand’ is a technical concept from Economics. Demand for product implies: • Desires to acquire it, • Willingness to pay for it, and • Ability to pay for it. 23

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