UNIT 1: BASIC CONCEPTS AND

PRINCIPLES • Contents: (6 Hrs)

• 1.1 Definition

• 1.2 Nature and Scope of Economics-Micro Economics and Macro Economics.

• 1.3 Managerial Economics and its relevance in business decisions.

• 1.4 Fundamental Principles of Managerial Economics –

a) Incremental Principle,

b) Marginal Principle,

c) Opportunity Cost Principle,

d) Discounting Principle,

e) Concept of Time Perspective.

f) Equi-Marginal Principle.

• 1.5 Utility Analysis. Cardinal Utility and Ordinal Utility.

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1.1 DEFINITION

• Economics

• In General way, economics is a social science which deals with theproduction, distribution and consumption of goods and services.There are a large number of economist give their differentdefinitions. Some say that there is no requirement of definition ofeconomics this is because economics growing continuously. But most ofthe economists agree with the view that defining economics is must.On the basis of these economist, the definition of economics isdivided into four parts such as:

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Definition of Economics

Wealth Definition

Adam SmithJ S SayL C MillSenior

Welfare Definition

MarshallCannon

BeveridgePenson

Scarcity Definition

Lord RobbinsScitovoskyStonier and

HagueHarvey

Growth-oriented Definition

Prof. Samuelson

BenhemC E FergeusonProf. J K Mehta

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WEALTH DEFINITION

• Adam Smith says “The self-interested pursuit of wealth may not be individually satisfying but leads to an aggregate increase in wealth that is in the best interests of a nation.”

• Adam Smith- Economics is an enquiry into the nature and causes of wealth of nation.

• J.B. Say- Economics is the science which treats of wealth.

• J.S. Mill-Economics is the practical science of the production and distribution of wealth.

• Senior- The subject treated by political economics is not happiness but wealth.

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WELFARE DEFINITION

• Alfred Marshall was born in London, on26 July 1842. Professor of PoliticalEconomy at the University of Cambridge from 1885 to 1908, he was thefounder of ·the Cambridge School of Economics which rose to greateminence in the 1920s and 1930s. Alfred Marshall’s magnum opus, thePrinciples of Economics was published in 1890. Marshall relates thedefinition of economics with material welfare.

• Marshall-Economics is the study of mankind in the ordinary business of life;it examines that part of individual and social action which is most closelyconnected with the attainment and with the use of material requited for wellbeing.

• Cannan-The aim of political economy is the explanation of general causeson which the material welfare of human being depends.

• Beveridge-Economics is the study of the general methods by which men co-operate to meet their material needs.

• Penson-Economics is the science of material welfare.

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SCARCITY DEFINITION

• Lionel Robbins was a peculiar Englishman in the economics world of the1920s. His tools were the London School of Economics and a famous 1932essay on economic methodology. It was his 1932 Essay on the Nature andSignificance of Economic Science where Robbins made his Continentalcredentials clear. He redefines the scope of economics to be “the sciencewhich studies human behavior as a relationship between scarce means whichhave alternative uses.”

• Lionel Robbins-Economics is a science which studies human behaviour as arelationship between ends and scarce means which have alternative uses.

• Scitovosky-Economics is the science concerned with the administration ofscarce resources.

• Stonier & Hague-Economics is the fundamentally a study of scarcity and theproblem which gives rise.

• Harvey-Economics is the study of how men allocate their resources toprovide for their wants.

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GROWTH ORIENTED DEFINITION

• Paul A. Samuelson has personified mainstream economics in thesecond half of the twentieth century. Paul Samuelson has not beenunjustly considered the incarnation of the economics ‘establishment’-and as a result, has been both lauded and vilified for virtuallyeverything right and wrong about it. Paul Samuelson’s most famouspiece of work, “Foundations of Economic Analysis” (1947), one of thegrand tomes that helped revive neoclassical economics and launchedthe era of the mathematization of economics. Samuelson was one ofthe progenitors of microeconomics and the Nee-Keynesian Synthesisin macroeconomics during the post-war period.

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CONTINUED…

• Prof. Samuelson-Economics is the study of how people and society end upchoosing with or without the use of money, to employ scarce productiveresources that could have alternative uses, it produce various commoditiesover time and distributes them for consumption, now or in the future, amongvarious persons and groups in society. It analyses cost and benefits ofimproving patterns of resource allocation.

• Benham-Economics is the study of the factors affecting employment andstandard of living.

• C. E. Ferguson-Economics is the study of the economic allocation of scarcephysical and human means (resources) among competing ends, an allocationthat achieves a stipulated optimizing or maximizing objectives.

• Porf. J.K. Mehta-Economics is a science which studies human behaviour as ameans to reach in a situation free of wants.

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1.2 NATURE AND SCOPE OF ECONOMICS-MICRO ECONOMICS AND MACRO ECONOMICS

• Economics as a Science:• if it is so, is it a positive or a normative science?

• A science is a systematised body of knowledge ascertainable by observation andexperimentation. It is a body of generalisations, principles, theories or laws which tracesout a causal relationship between cause and effect.

• For any discipline to be a science;

• (i) it must be a systematized body of knowledge;

• (ii) have its own laws or theories;

• (iii) which can be tested by observation and experimentation;

• (iv) can make predictions;

• (v) be self-corrective; and

• (vi) have universal validity.

• If these features of a science are applied to economics, it can be said that economics is ascience.

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NATURE OF ECONOMICS

• Economics as an Art:

• Art is the practical application of scientific principles. Science laysdown certain principles while art puts these principles into practicaluse. To analyze the causes and effects of poverty falls within thepurview of science and to lay down principles for the removal ofpoverty is art. Economics is thus both a science and an art in thissense.

• “Economics should not be considered as a tyrannical oracle whoseword is final. But when the preliminary work has been truly done,Applied Economics will at certain times on certain subjects speak withthe authority to which it is entitled.” Economics is thus regarded botha science and an art, though economists prefer to use the termapplied economics in place of the latter.

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SCOPE OF ECONOMICS

• Microeconomics

• Macroeconomics

• International economics

• Public finance

• Development economics

• Health economics

• Environmental economics

• Urban and rural economics

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MICRO & MACROECONOMICS

• Subject- matter of economics can be sub- divided in toMicroeconomics and Macroeconomics.

• These terms were first coined and used by Ragnar Frisch.

• Acc. To K E Boulding:

• “Microeconomics is the study of particular firms, particular households,individual prices, wages, incomes, individual industries, particularcommodities.”

• “Macroeconomics deals not with individual quantities as such but withaggregates of these quantities, not with individual incomes but withnational income; not with individual prices but with general price level;not with individual output but with national output.”

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1.3 MANAGERIAL ECONOMICS AND ITS RELEVANCE IN BUSINESS DECISIONS.

• To quote Mansfield, "Managerial Economics is concerned with theapplication of economic concepts and economic analysis to the problems offormulating rational managerial decisions."

• According to McNair and Meriam, "Managerial economics is the use ofeconomic modes of thought to analyse business situations."

• "Managerial Economics is concerned with the application of economicprinciples and methodologies to the decision making process within the firmor organisation under the conditions of uncertainty," says Prof. Evan JDouglas.

• Spencer and Siegelman define it as "The integration of economic theorywith business practice for the purpose of facilitating decision making andforward planning by management."

• According to Hailstones and Rothwel, "Managerial economics is theapplication of economic theory and analysis to practice of business firmsand other institutions."

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MANAGERIAL ECONOMICS

• Coordination

• An activity or an ongoing process

• A purposive process

• An art of getting things done by other people.

Management

• Human wants are virtually unlimited and insatiable, and

• Economic resources to satisfy these human demands are limited.

Economics• Thus managerial economics

is the study of allocation ofresources available to afirm or a unit ofmanagement among theactivities of that unit.

Managerial Economics

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SCOPE OF MANAGERIAL ECONOMICS

There are four groups of problem in both decision making and

forward planning.

Resource allocation

Inventory and

queuing problem

Pricing problems

Investment problems

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RELATIONSHIP OF MANAGERIAL ECONOMICS WITH DECISION SCIENCES

• Economics is linked with various other fields of study like:

• Operation Research

• Theory of Decision Making

• Statistics

• Management Theory and Accounting

• Satisficing instead of maximizing

• Managerial Accounting

Economics and other Disciplines

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1.4 FUNDAMENTAL PRINCIPLES OF MANAGERIAL ECONOMICS –

a) Incremental Principle,

b) Marginal Principle,

c) Opportunity Cost Principle,

d) Discounting Principle,

e) Concept of Time Perspective.

f) Equi-Marginal Principle.

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MARGINAL AND INCREMENTAL PRINCIPLE

• Incremental concept is similar to the concept of marginal value, but with a difference. Marginal principle is theoretical while incremental concept is practical in nature.

• Marginal concept is used when calculating per unit costs for bulk purchases, the principle of incrementalism comes in to play when the inputs are large units like in case of airplane.

• The use of incremental concept in business decision making is known as incremental reasoning.

• IC is used more often in business decision making than MA.

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OPPORTUNITY COST PRINCIPLE

• The idea is that anything you must give up in order to carry out a particulardecision is a cost of that decision. This concept is applied again and againthroughout modern economics.

• Scarcity: According to modern economics, scarcity exists whenever there isan opportunity cost, that is, where-ever a meaningful choice has to bemade.

• Production Possibility Frontier: The production possibility frontier is thediagrammatic representation of scarcity in production.

• Comparative Advantage: A very important principle in itself and a key tounderstanding of international trade the principle of comparativeadvantage is at the same time an application of the opportunity costprinciple to trade.

• Discounting of Investment Returns: Another application of the opportunitycost principle that is very important in itself, this one tells us how to handleopportunities that come at different times.

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1.5 UTILITY ANALYSIS. CARDINAL UTILITY AND ORDINAL UTILITY.

•After Demand Analysis…!

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1.5 UTILITY ANALYSIS. CARDINAL UTILITY AND ORDINAL UTILITY.

• Utility Analysis

• The decision of a consumer depends upon the concept of individual benefit,also known as utility. If consumer gets more benefit from the product he willready to spend more on the product and the vice-versa.

• Consumers are able to order their preference depending on the utility theyget from the consumption of the particular product. Utility can be difficult tomeasure.

• No consumer is able to measure the utility in quantitative terms. But he canorder his preference according to the satisfaction from the consumptiongoods. Thus, there are two class of thoughts about the measurement ofutility.

• One states that utility can be measured in numbers or monetary terms,another says that satisfaction utility derived from the consumption of goodscan only be ordered. These two distinctions are called cardinal utility andordinal utility.

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CARDINAL UTILITY AND ORDINAL UTILITY

• Utility is an economic term referring to the totalsatisfaction received from consuming a good or service.For example, satisfaction you get by consuming a cup oftea is the utility of that cup of tea. If this measure isgiven, one may think of increasing or decreasing utility,and thereby explain economic behavior in terms ofattempts to increase one’s utility. Changes in utility aresometimes expressed in fictional units called utils. Thereare mainly two kinds of measurement of utilityimplemented by economists: cardinal utility and ordinalutility.

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CARDINAL UTILITY AND ORDINAL UTILITY

• Utility was originally viewed as a measurable quantity,so that it would be possible to measure the utility ofeach individual in the society with respect to each goodavailable in the society, and to add these together toyield the total utility of all people with respect to allgoods in the society. Society could then aim to maximisethe total utility of all people in society, or equivalentlythe average utility per person. This conception of utilityas a measurable quantity that could be aggregated(summed up) across individuals is called cardinal utility.

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CARDINAL UTILITY

• Cardinal utility quantitatively measures the preference of anindividual towards a certain commodity. Numbers assigned todifferent goods or services can be compared.

• Example: For a coffee addict, a utility of 100 utils towards acup of cappuccino is twice as desirable as a cup of tea with autility level of 50 utils.

• The concept of cardinal utility suffers from the absence of anobjective measure of utility.

• For example, the utility gained from consumption of aparticular good by ‘A’ will be different than ‘B’.

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ORDINAL UTILITY

• Ordinal utility represents the utility, orsatisfaction derived from the consumption ofgoods and services, based on a relativeranking of the goods and services consumed.With ordinal utility, goods are only ranked onlyin terms of more or less preferred, there is noattempt to determine how much more one goodis preferred to another.

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ORDINAL UTILITY

• Example: You may prefer to consume or buy more apples than bananaswhile your friend may prefer to consume or buy more bananas than apple.

• The modern economists have discarded the concept of cardinal utility andhave instead employed the concept of ordinal utility for analysing consumerbehaviour. The concept of ordinal utility is based on the fact that it may notbe possible for consumers to express the utility of a commodity in absoluteterms but it is always possible for a consumer to tell introspectively whethera commodity is more or less or equally useful as compared to another.

• Example: A consumer may not be able to tell that an ice cream gives 5 utilsand a chocolate gives 2 utils. But he or she can always tell whetherchocolate gives more or less utility than ice cream.

• This assumption forms the basis of the ordinal theory of consumer behaviour.Ordinal utility is the underlying assumption used in the analysis ofindifference curves.

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MARGINAL UTILITY ANALYSIS

• Marginal utility is the additional amount of satisfactionobtained from consuming one additional unit of a good. Totalutility is the overall amount of satisfaction obtained fromconsuming several units of a good. While the maximization oftotal utility represents the ultimate goal of consumption, theanalysis of consumer behaviour gives greater emphasis on themarginal utility. As consumer proceeds with his consumptiontotal utility increases as more of a good is consumed, but themarginal utility decreases with the consumption of eachadditional unit. The decrease in marginal utility with anincrease in the consumption of a good reflects law ofdiminishing marginal utility.

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THE LAW OF DIMINISHING MARGINAL UTILITY: MARSHILLIAN

APPROACH

• Marginal utility refers to the change in satisfaction which results whena little more or little less of that good is consumed.

• The law of diminishing marginal utility says that with the increase inthe consumption of a good there is a decrease in the marginal utilitythat person derives from consuming each additional unit of thatproduct.

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INDIFFERENCE CURVES

• An indifference curve may be defined as the locus of points.Each point represents a different combination of two substitutegoods, which yields the same utility or level of satisfaction tothe consumer. Therefore, he/she is indifferent between any twocombinations of goods when it comes to making a choicebetween them. Such a situation arises because he/she consumesa large number of goods and services and often finds that onecommodity can be substituted for another. This gives him/her anopportunity to substitute one commodity for another, if needarises and to make various combinations of two substitutablegoods which give him/her the same level of satisfaction. If aconsumer faced with such combinations, he/she would beindifferent between the combinations.

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FIGURE BELOW SHOWS THE INDIFFERENCE CURVE DRAWN ON THE BASISOF THE FIGURE GIVE IN TABLE. IT DEPICTS, IN GENERAL, ALLCOMBINATIONS OF TWO GOODS WHICH YIELD THE SAME LEVEL OFSATISFACTION TO THE CONSUMER. THE CONSUMER IS INDIFFERENT ABOUTANY TWO POINTS LYING ON THIS CURVE.

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ASSUMPTIONS

• The following assumptions about the consumer psychology areimplicit in indifference curve analysis:

• Transitivity: If a consumer is indifferent to two combinations of twogoods, then he is unaware of the third combination also.

• Diminishing marginal rate of substitution: The rarer the availability ofa good, the greater is its substitution value. For example, water has ahigh substitution value as it is a scarce resource.

• Rationality: The consumer aims to maximise his total satisfaction andhas got complete market information.

• Ordinal utility: Utility in this approach is not measurable. A consumercan only specify his preference for a particular combination of twogoods, he cannot specify how much.

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PROPERTIES OF INDIFFERENCE CURVE

• Indifference curves have the four basic characteristics:

• 1. Indifference curves have a negative slope

• 2. Indifference curves are convex to the origin

• 3. Indifference curves do not intersect nor are they tangent to oneanother

• 4. Upper indifference curves indicate a higher level of satisfaction.

• These characteristics or properties of indifference curves, in fact,reveal the consumer’s behaviour, his choices and preferences. Theyare, therefore, very important in the modern theory of consumerbehaviour. Now, we will observe their implications.

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BUDGET LINE

• THE BUDGET CONSTRAINT Having described preferences,next we determine the consumer’s alternatives. The amount ofgoods he can purchase depends on his available income andthe goods’ prices. Suppose the consumer sets aside Rs. 200each week to spend on the two goods. The price of good X isRs. 40 per unit, and the price of Y is Rs. 20 per unit. Then he isable to buy any quantities of the goods (call these quantities Xand Y) as long as he does not exceed his income. If he spendsthe entire Rs. 200, his purchases must satisfy:

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40X + 20Y = 200

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CONSUMER EQUILIBRIUM

• If we superimpose the indifference mapand budget line as in Figure shown above,we find that a consumer has to decide topurchase a particular combination (C) asit falls on his budget line, though adifferent combination (D) would be moredesirable as it will give a higher level ofsatisfaction. At his point of equilibrium C,the price line is touching the indifferenceline tangentially meaning that the slopesare equal. The slope of indifference curveindicates the marginal rate of substitutionbetween X and Y, and the slope ofbudget line indicates the ratio of price ofX to that of Y. Thus the principle ofconsumer's equilibrium works out; themarginal rate of substitution between Xand Y must be proportional to the ratio ofprice of X to that of Y.

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