MARGINAL AND INCREMENTAL PRINCIPLE

A manager has to use resources of production carefully as they are scarce. Marginal analysis helps to assess the impact of a unit change in one variable on the other. For example, a firms’ decision to change prices would depend on the resulting change in marginal revenue and marginal cost. Changes in these variables would, in turn, depend on the units sold as a result of a change in price. Change in the price is desirable if the additional revenue earned is more than the additional cost. Similarly, decision on additional investment is taken on the basis of the additional return from that investment, that is, the marginal changes.

The word ‘marginal’ is used for such small changes. In contrast, incremental concept applies to changes in revenue and cost due to a policy change. For example, additional cost of installing computer facilities will be incremental cost and the additional revenue earned due to access to Internet will be incremental revenue. Thus, a change in output because of a change in process, product or investment is regarded as an incremental change. Incremental reasoning highlights the fact that incremental cost, rather than full cost, should be taken in consideration to assess the profitability of a decision. The incremental principle states that a decision is profitable when:

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 costs more than revenues. Suppose a firm gets an order that brings additional revenue of Rs 3,000. The cost of production from this order is: Rs Labour 800 Materials 1,300 Overheads 1,000 Selling and administration expenses 700 Full cost 3,800

At a glance, the order appears to be unprofitable. But suppose the firm has some idle capacity that can be utilised to produce output for new order. There may be more efficient

use of existing labour and no additional selling and administration expenses to be incurred. Then the incremental cost to accept the order will be:

Rs

Labour

600

Materials 1,000 Overheads 800 Total incremental cost 2,400

Incremental reasoning shows that the firm would earn a net profit of Rs 600 (Rs 3,000 – 2,400), though initially it appeared to result in a loss of Rs 800. The order should be accepted.

EQUI–MARGINAL PRINCIPLE

The equi-marginal principle 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 is the same, in a given use. For example Fundamental Concepts of Managerial Economics a consumer maximises utility or satisfaction from consumption of successive units of goods X, Y, and Z will allocate his consumption budget such that M U P M U P M U P x x y y z z = =

where MU represents marginal utility and P the price of the good. Similarly, a producer seeking maximum profit will use the technique of production which would ensure that

M RP M C M RP M C M RP M C 1 1 2 2 n n

= = . . . . . . where MRP is the marginal revenue product of inputs and MC shows marginal cost.

OPPORTUNITY COST PRINCIPLE

The opportunity cost principle states that a decision to accept an employment for any factor of production is profitable if the total reward for the factor in that occupation is greater or at least no less than the factor’s opportunity cost. This cost arises because most economic resources have more than one use. The opportunity cost is the amount of subjective value foregone in choosing one alternative over the next best alternative. It is the ‘cost of sacrificed alternatives’.

If there are no sacrifices, there is no cost. Like the opportunity cost of using a machine to produce one product is the earnings foregone which would have been earned from producing other products. Similarly, the opportunity cost of using the premises for own business is the rent that would have been earned by giving it on rent.

TIME PERSPECTIVE PRINCIPLE

The time perspective principle argues that a manager should consider both short run and long run while taking decisions. Economists regard short run as the current period whereas long run as a future period. Some inputs of production are regarded as fixed in the short run. It is a time period in which the existing producers respond to price changes by using more or less of their variable inputs. From the standpoint of consumers, the short run is a period in which they respond to price changes with the prevalent tastes and preferences.

Long run is a time period in which new sellers may enter a market or a seller already existing may leave. This time period is sufficient for both old and new sellers to vary all their factors of production. From the standpoint of consumers, long run provides enough time to respond to price changes by actually changing their tastes and preferences or their alternative goods and services.

DISCOUNTING PRINCIPLE Discounting principle states that when a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible. This is because money has time value, that is, a rupee to be received in the future is not worth a rupee today. Therefore, it is necessary to have techniques for measuring the value today (i.e., the present value) of rupee to be

received or paid at different points in future. If Managerial Economics interest rate is .10 and if the rupee is to be received in 4 years (n = 4), the present value of rupee equals 1 1 1 1.4641Rs0.683 1+ i +.10 n 4 a f a f

= = =

In other words, the present value of the rupee is 68.3 paise. Similarly, we can calculate the present value for longer periods. Present value of an annuity (a series of periodic equal payments) can be regarded as the sum of the present values of each of several amounts. For example, the present value of Re. 1 to be received at the end of each of the next 5 years, if the interest rate is .10, is

1 1+ i 1 1+.10 1 1+.10 1 1+.10 t t=1 n t 2 t=1 5 3 4 5 1 1+.10 1 1+.10 1 1+.10 b g b gb gb ga f a f a f

∑ = = + ∑ + + + = .90909 + .82645 + .75131 + .68301 + .62092 = Rs 3.79 Check Your Progress Discuss, with a real world example, the role of time perspective principle in managerial decision-making. Notes: (i) Write your answers in the space given below. (ii) Check your answer with the one given at the end of this lesson.

ROLE OF MANAGERIAL ECONOMIST

Companies like Tatas, DCM, HLL and IPCL employ managerial economists to guide them in making appropriate economic decisions. A managerial economist makes an assessment of change in the consumer preferences, input prices, and related variables to make successful forecasts of their probable effect on the internal policies of the firm. They inform the management of a change in the competitive environment in which a firm functions, and suggest suitable policies for solution of problems like:

1. What product and services should be produced? 2. What inputs and production techniques should be used? 3. How much output should be produced and at what prices should it be sold? 4. What are the best sizes and locations of the new plant? 5. When should the equipment be replaced? 6. How should the available capital be allocated?

A managerial economist has to evaluate changes in the macroeconomic indicators like national income, population, and business cycles, and their likely impact on the functioning of the firm. He also studies the impact of changes in fiscal policy, monetary policy, employment policy and the like on the functioning of the firm. These topics come under the purview of macroeconomics. Therefore, they deserve a separate treatment. The scope of managerial economics is restricted to microeconomics.

Fundamental Concepts of Managerial Economics

IMPORTANCE OF MANAGEMENT DECISION

MAKING Managerial Economics serves as "a link between traditional economics and the decision making sciences" for business decision-making. The best way to get acquainted with managerial economics and decision-making is to come fact to face with real world decision problems. Tata's Vision 2000

Presently there are about 87 firms in the Tata empire. As many as 16 have recorded losses in 1995- 96. Tata's companies that are in the limelight are TISCO, TELCO, ACC, Tata Exports and Tata Chemicals.

Keeping these figures in mind, Tatas are planning refocusing exercises like Divestment - mergers Amalgamations - takeovers Figure 2.1: Decision Making To create a learner and suggestive group with an estimated turnover of Rs 1,10,000 crore by 2000. From being production-led to beings consumer and market-led; being up in top three in every segment.

Mr Tata's "Vision 2000" is a group. Why not give someone else a chance to run your business more efficiently if you cannot do so? It makes better economic as well as business sense. But then, the ball is in the court of Tatas. The What and How to do is their prerogative.

LET US SUM UP In this lesson we have studied the fundamental concepts of managerial economics. This most important concept, in this regard, is the concept of marginalism. Marginal analysis helps to assess the impact of a unit change in one variable on the other. The next important concept, used in managerial economics, is opportunity cost. It is the amount of subjective value foregone in choosing one alternative over the next best alternative. Other important concepts, we have discussed in this lesson, are time perspective principle and discounting principle.

LESSON END ACTIVITY Calculate using the best estimate you can make: (i) Your opportunity cost of attending college. (ii) Your opportunity cost of taking this course (e.g. MBA).

KEYWORDS Marginalism Marginal Revenue Marginal Cost

Incremental Cost Incremental Revenue Equi-marginal Principle Opportunity Cost Net Present Value

QUESTIONS FOR DISCUSSION 1. What is the importance of management decision-making? 2. Write short notes (about 200 words) on the following: (a) The marginal concept (b) The incremental concept (c) Opportunity cost 3. What is the difference between marginalisms and incrementalism? State the significance of marginal analysis in decision-making. 4. What are equi-marginal principle and time perspective principle? Describe their use in allocation of resources of a firm.