Economics Chapter1

Chapter 1

Basic Concepts and

Principles

Lecture plan

Objectives

What is Economics?

Basic Assumptions

Types of Economic Analysis

Managerial Economics

Managerial Decisions

Economic Principles Relevant to Managerial Decisions

Production Possibilities Curve

Managerial Economics and Functions of Management

Relationship with Other Disciplines

Summary

Objectives

To introduce key economic concepts like scarcity,rationality, equilibrium, time perspective andopportunity cost.

To explain the basic difference betweenmicroeconomics and macroeconomics.

To help the reader analyze how decisions are madeabout what, how and for whom to produce.

To define managerial economics and demonstrate itsimportance in managerial decision making.

To discuss the scope of managerial economics andits relationship with various other disciplines andfunctional areas.

What is Economics?

Discusses how a society tries to solve the humanproblems of unlimited wants and scarce resources.

Scientific study of the choices made by individuals andsocieties with regard to the alternative uses of scarceresources employed to satisfy wants.

Theoretical aspect and an applied science in its practicalaspects.

Not an exact science; An “art” as well

A social science

Deals with the society as a whole and human behaviour inparticular

Studies the production, distribution, and consumption ofgoods and services.

A science in its methodology, and art in its application.

Basic Assumptions

Ceteris Paribus

Latin phrase

“With other things (being) the same” or “all other

things being equal”.

Rationality

Consumers maximize utility subject to given money

income.

Producers maximize profit subject to given resources

or minimize cost subject to target return.


Micro and Macro

Microeconomics (“micro” meaning small): study ofthe behaviour of small economic units

An individual consumer, a seller/ a producer/ afirm, or a product.

Focus on basic theories of supply and demand inindividual markets

Macroeconomics (“macro” meaning large):study of aggregates. Industry as a unit, and not the firm.

Focus on aggregate demand and aggregatesupply, national income, employment, inflation,etc.


Positive and Normative

Positive economics: “what is” in economic matters

Establishes a cause and effect relationship between

variables.

Analyzes problems on the basis of facts.

Normative economics: “what ought to be” in

economic matters.

Concerned with questions involving value judgments.

Incorporates value judgments about what the economy

should be like.

Short Run and Long Run

Short run: Time period not enough for consumers and

producers to adjust completely to any new situation.

Some inputs are fixed and others are variable

Long run: Time period long enough for consumers and

producers to adjust to any new situation.

All inputs are variable

Decisions to adjust capacity, to introduce a larger

plant or continue with the existing one, to change

product lines.


contd..


Partial and General Equilibrium

Partial equilibrium analysis: Related to micro analysis

Studies the outcome of any policy action in asingle market only.

Equilibrium of one firm or few firms and notnecessarily the industry or economy.

General equilibrium: explains economic phenomenain an economy as a whole.

State in which all the industries in an economy arein equilibrium.

State of full employment


Application of economic theory and the tools of analysisof decision science to examine how an organisation canachieve its objectives most effectively

Study of allocation of the limited resources available to afirm or other unit of management among the variouspossible activities of that unit

Applies economic theory and methods to business andadministrative decision-making

Application of economic principles and methodologies tothe decision-making process within the firm ororganization

Micro as well as Macro

Applied microeconomics: demand analysis, cost andproduction analysis, pricing and output decisions

Macroeconomic: national income, inflation and stages ofrecession and expansion

Normative Bias

Prescriptive: States what firms should do in order to reachcertain objectives.

Decides on whether or not the probable outcome of amanagerial decision is desirable.

Decisions Resulting in Partial Equilibrium

Decisions taken by any firm would relate to the equilibrium of that particular firm.

Deals with partial equilibrium analysis

Managerial EconomicsContd…

Economic Principles Relevant to Managerial Decisions

Concept of scarcity Unlimited human wants

Limited resources available to satisfy such wants

Best possible use of resources to get:

maximum satisfaction (from the point of view of consumers) or

maximum output (from the point of view of producers or firms)

Concept of opportunity cost Opportunity cost is the benefit forgone from the alternative

that is not selected.

Highlights the capacity of one resource to satisfy multitude ofwants

Helps in making rational choices in all aspects of business,since resources are scarce and wants are unlimited

Concept of margin or increment

Marginality: a unit increase in cost or revenue or

utility.

Marginal cost: change in Total Cost due to a unit change in

output.

Marginal revenue: change in Total Revenue due to a unit

change in sales.

Marginal utility: change in Total Utility due to a unit change

in consumption.

Incremental: applied when the changes are in bulk,

say 10% increase in sales.

Economic Principles Relevant to Managerial Decisions Contd…

Economic Principles Relevant to

Managerial Decisions

Discounting Principle

Time value of money : Value of money depreciates with time

A rupee in hand today is worth more than a rupee received tomorrow.

Outflow and inflow of money and resources at different points of time

PVF =

where

PVF = Present Value of Fund,

n = period (year, etc.)

R = rate of discount

nr)1(

1

Production Possibilities Curve

Shows the different combinations of the quantities of twogoods that can be produced (or consumed) in aneconomy at any point of time.

Depicts the trade off between any two items produced(or consumed).

Highlights the concepts of scarcity and opportunity cost

Indicates the opportunity cost of increasing one item's production(or consumption) in terms of the units of the other forgone

Slope of the curve in absolute terms

Assumptions

The economy is operating at full employment.

Factors of production are fixed in supply; they can however be reallocated among different uses.

Technology remains the same.

Food

Clothing

FQ

CQ

Q

FP

CP

P

O

Figure 1.3: PPC for the Society

Production Possibilities CurveContd…

Productively

Inefficient Area

Technically

Infeasible Area

All points on the PPC (like P and Q) are points ofmaximum productive efficiency.

In the figure, OFp of food and OCp of clothing can beproduced at Point P and OFQ of food and OCQrespectively at point Q, when production is run efficiently.

All points inside the frontier are feasible but productivelyinefficient.

All points to the right of (or above) the curve aretechnically impossible (or cannot be sustained for long).

A move from P to Q indicates an increase in the units ofclothing produced and vice versa.

It also implies a decrease in the units of food produced.This decrease in the units of food is the opportunity costof producing more clothing.

Production Possibilities CurveContd…

Managerial Economics and

Functions of Management

All functional areas have to find the mostefficient way of allocating scarceorganizational resources

Managerial economics:

Facilitates the process of evaluatingrelationships between functional areas

Helps in making rational decisions acrossmanagerial functions.



Financial Management From where to collect resources

Equity

Debt

How to allocate resources

How much profit to be retained/distributed

Human Resource Management Recruitment

Wage and Salary

Training and development

Retirement

Contd…



Marketing Management Which product

For whom

What price

How to sell

Operations Management Which technology

Inputs

Processing

Information System Management Communication channels

Use of information Technology

Relationship Other Disciplines

Economic TheoryMicroeconomics

Theory of firm

Theory of consumer behaviour (demand)

Production and cost theory (supply)

Market structure and competition

Price theory

Macroeconomics

National income and output

Business cycle

Inflation

Quantitative AnalysisNumeric and algebraic analysis

Optimization

Discounting and time value of money

techniques

Statistical estimation and forecasting

Game theory


Solutions to Managerial Decision Making

Quantity and quality of product

Price of product

Marketing Management

Financial Management

Human Resource Management

Research and Development

Summary

• Economics studies the choices made by individuals and societies inregard to the alternative uses of scarce resources which are employed tosatisfy unlimited wants.

• Microeconomics is the study of the behaviour of individual economicunits, such as an individual consumer, a seller, a producer, a firm, or aproduct.

• Macroeconomics deals with the study of aggregates, the economy as awhole.

• Ceteris paribus is a Latin phrase, literally translated as “with other things(being) the same”.

• The assumption of rationality means that consumers and firms measureand compare the costs and benefits of a decision before going ahead forthat decision.

• Partial equilibrium analysis studies the outcome of any policy action in asingle market only, while general equilibrium analysis seeks to explaineconomic phenomena in an economy as a whole.

• Opportunity cost is the benefit forgone from the alternative that is notselected.

Summary

• Concept of Time value of money tells that Value of moneydepreciates with time.

• Concept of Marginal/increment tells about impact ofunit/proportionate change in cost/revenue on decision making.

• Managerial economics is a means to finding the most efficient wayof allocating scarce organizational resources and reaching statedobjectives. It is micro as well as macro in nature; it has a normativebias, and deals with partial equilibrium.

• Production Possibilities Curve (PPC) is a graph that shows thedifferent combinations of the quantities of two goods that can beproduced (or consumed) in an economy, subject to the limitedavailability of resources.

• The knowledge of managerial economics helps to understand theinterrelationships among the various functional units of any firm(namely production, marketing, HR, finance, IT and legal)

• Decision sciences provide the tools and techniques of analysisused in managerial economics, in particular numerical andalgebraic analysis, optimization, statistical estimation andforecasting.

Economy & Finance

Economics Chapter1