1

MANAGERIAL ECONOMICS

2

Managerial + Economics

• Managerial Economics is economics applied in decision-making

• Link between abstract theory and managerial practice.

• Analysis for identifying problems, organizing information and evaluating alternatives.

3

Managerial Economics & Business Decision-making

Decision Problem

Managerial Economics

Optimal Solution to Business Problems

Tools & Techniquesof Analysis

TraditionalEconomics

4

Nature of Managerial Economics

Spencer and Siegelman point to the fact that “Managerial Economics.. is the integration of economic theory and business practice for the purpose of facilitating decision-making and forward planning by management.”

5

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’.

• Knowledge of managerial economics helps in making wise choices.

6

Significance of Managerial Economics

• In order to enable the manager to become a more competent model builder,managerial economics provides a number of tools and techniques.

• Managerial economics provides most of the concepts that are needed for the analysis of business problems.

• Managerial economics is helpful in making decisions.

• Evaluating choice of alternatives.

7

Scope of Managerial Economics

Following aspects constitute its subject matter:-

Objectives of a Business Firm Demand Analysis and Demand Forecasting Production and Cost Competition Pricing and Output Profit Investment and Capital Budgeting and Product Policy, Sales Promotion and Market Strategy.

8

Managerial Economics & Other Disciplines

• Managerial Economics & Traditional Economics

• Managerial Economics & Operations Research

• Managerial Economics & Mathematics

• Managerial Economics & Statistics

• Managerial Economics & the Theory of Decision-making

9

FUNDAMENTAL CONCEPTS

10

Fundamental Concepts

• Incremental Reasoning• Opportunity Cost• Contribution• Time Perspective• Time Value of Money – Discounting

Principle &• Equi-Marginal Principle

11

1.Incremental ReasoningThe two basic concepts in the incremental analysis are : incremental cost and incremental revenue.

• Incremental cost may be defined as the change in total cost as a result of change in the level of output, investment, etc

•Incremental Revenue is change in total revenue resulting from change in level of output , price etc.

Use of Incremental Reasoning

While taking a decision, a manager always determines the worthwhile ness of a decision on the basis of criterion that the incremental revenue should exceed incremental cost.

12

Illustration: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 Rs.2400

Labour Rs.400

Materials 800

Overheads 200

Full cost Rs.1400

13

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

14

2.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.

15

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.

16

3.Contribution

•Contribution tells us about the contribution of a unit of output to overheads and profit.

•It helps in determining the best product mix when allocation of scarce resources is involved.

•It also indicates whether or not it is advantageous to accept a fresh order, to introduce a new product, to shut down to continue with the existing plant etc.

•Unit contribution is the per unit difference of incremental revenue from incremental cost

17

4.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.

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

18

5.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.

•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.

Illustrations

Suppose a sum of Rs.100 is due after 1 year. Let the rate of interest be 10% . We can determine the sum to be invested now so as to produce the return (R) of Rs.100 at the end of 1 year. The present value of the discounted value of Rs. 100 will then be,

19

n

kk

kn

n

nn

i

R

i

R

i

R

i

R

The

i

R

i

R

i

R

We

RsRs

i

RsV

Rsi

RV

13

32

21

33

221

n21

222

1

11..,..........

1)1(i)(1

RV

be thus wouldyearsn for luespresent va of sum

1..,..........

1,

)1(,

i)(1

R

)as ...RR,R (i.e years

n over spread income of stream a ofrth present wo the writecan thus

64.8221.1

100.

)10.1(

100.

1

100.

be, dlater woul years twodue Rs.100 of luepresent vaA periods.

longer of luepresent va thefind toused becan reasoning same The

90.90.10.1

100

1

20

6.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.

21

The Equi-Marginal Principle

3530201512

403020100

5045352010

1st

2nd

3rd

4th

5th

Project CProject BProject A

Marginal Productivity (MP)Units of Expenditure(Rs.10 million)

Marginal Productivity (MP) Schedule of Projects A, B, and C

22

The Equi-Marginal Principle

return.or ty productivi marginal

gdiminishin subject to is uses ealternativ in various investment the(iii)

and uses ealternativ have resources (ii)

resources investible limited have firms (i)

only where applied becan principle marginal - equi The

...

such that proportion ain resources its allocates firms

maximizing (gain)profit a that suggests principle marginal equi The

NCBA MPMPMPMP