- 1. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 1 MANAGERIAL
ECONOMICS FOR MM FT SEMESTER 1 2013-15 UNIT 1 - INTRODUCTION TO
ECONOMICS AND MANAGERIAL ECONOMICS a. NATURE b. SCOPE c.
CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS d.
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH ECONOMICS, OPERATION
RESEARCH, DECISION MAKING, STATISTICS, ACCOUNTING ETC. NATURE -
Application of economic theory and tools of analysis of decision
science to examine how an organization can achieve its objectives
most efficiently- Salvatore Spencer and Siegelman: Integration of
economic theory with business practice for the purpose of
facilitating decision making and forward planning by management
Evan Douglas: Application of economic principles and methodologies
to the decision-making process within the firm or organizationunder
conditions of uncertainty Decision Making Process 5 Stages of
Decision making Process: 1. Define the problem 2. Determine the
objective 3. Identify possible solutions 4. Select the best
possible solution 5. Implement the decision Importance of
Quantitative Tools Analysis of variables is a key procedure in
economic analysis. Economic research and policy-making require
up-to-date data and extensive analysis. Use of Mathematical tools
Use of Statistical Techniques Time Series: For Demand forecasting
Regression: Two or multiple variables used to study
interrelationships, estimation and prediction Measures of central
tendency and variation
2. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 2 Role of
Economics What is the role of Economics in Business? Costs, prices,
output, compensation, strategic behavior, importantly, ethics The
Big Picture- Whose job? The BIG Picture Product Market
FirmsHouseholds Factor Market Income spent Goods demand Inputs
supplied Income earned Inputs demand Factor costs Goods supplied
Revenue earned Economic theory forms the basis for different
management areas such as accounts, finance, marketing, systems and
operations. A manager has to deal with problems pertaining to the
individual firm as well as domestic and global environment.
Microeconomics: Deals with individual unit Macroeconomics: Deals
with aggregates Microeconomics: Theory of demand and supply-
consumer behavior, demand theory, demand forecasting and factors
affecting individual and market supply- Helps in choice of
commodities for production Theory of Production: Production
function and laws of returns to scale etc- gives an idea about I/O
relations, input requirement size of firm, technology choice of
output. Helps producer to plan production, cost and budget. Market
Analysis: helps understand degrees of competition, pricing-output
decisions, price discrimination, monopoly power, and advertising 3.
P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 3 Profit Analysis:
Provides logical analysis of break-even point, emergence of
profits, profit- maximizing output, dealing with risk and
uncertainty Theory of capital: Along with quantitative techniques
enables investors to calculate cost of capital, efficiency of
capital, efficient allocation of capital, and choice of projects as
per risk- return analysis Behavior of macroeconomic indicators:
GDP, GNP, GDCF, GDS, HDI etc. Business Cycles Inflation- Employment
Fiscal Policy Monetary Policy Foreign Trade: Imports and exports,
Exchange rate, trade policies and capital flows Macro economics:
How variables and policies impact business? Role of Economics in
Business: Economics is a tool, means to an end To help Efficient
allocation and achieve business objectives Optimizing behavior-
Maximize goals, minimize costs under constraint Logic, tools and
techniques of economics to analyze business problems, evaluate
business options and opportunities with a view to arriving at an
appropriate business decision. 3 main contributions of economic
theory to business economics, according to Baumol: o Analytical
models: To recognize the structure of managerial problems,
eliminate minor details, and concentrate on main issue o
Ascertaining relevant variables and specifying the data - Even if
the models are not directly applicable, they enhance capabilities
of business analyst o Economic theories offer conceptual clarity to
avoid conceptual pitfalls Provides consistency to business analysis
Role of Managerial Economist: A. To decide What to produce? Where?
How? How much? Allocation of resources? For whom to produce? At
what price to sell? B. Plan and control business operations- Cost
minimization Profit maximization Managing competition Economic
intelligence Market research C. Uncertainty & Risk management
4. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 4 Forecast
change in environment and policies- domestic and international To
manage change in global scenario Everything comes at a price-
quality is not free Growing Challenges to the Managerial Economist:
Globalization - People-goods-services- communication- Finance-
Ideas o Global corporations o Research & production facilities
across countries o Global markets o Global Finance o Employment
Diversity o Global work culture o Resource base: Crossing
boundaries o Global management practices o Outsourcing o Increased
competition o Increased Opportunity o Tastes converging
internationally? o Customizing to local tastes o Not merely
exporters, but need to be insiders in major markets Computerization
and Technology o Easier model-building and simulation o Quick and
complicated data analysis o Rapid spread of information o Internet
changing both buyers and sellers o Videoconferencing- saving cost
and time o Paperless administration o Speed of dispatch, lower
inventories, less waste Dismantling of Traditional Hierarchies o
Information today can be transmitted directly from top management
to workers o Middle managers are today increasingly being used to
shelter top management from day-to-day activities Changing Basis
for Value Creation o Peter Drucker: World is moving from economy of
goods to an economy of knowledge o Creation of value increasingly
based on knowledge and communications and not natural resources and
physical labour Bridging the gap between theory and Practice : o
Real world is complex, chaotic, interdependent as against
simplifying economic assumptions o Not tailor-made solutions but a
framework of logical thinking 5. P.S CHANDIRAMANI @ I.M.S ,
D.A.V.V, INDORE Page 5 The Global business Leader has to Imbibe and
inculcate essential qualities such as o Global outlook o Managing
diversities o Flexibility with efficiency o Long-term goals with
steps and migration path o Speed and stamina for transformation
Essentially, 3 sets of skills: o Human- understand, work with and
motivate with other people as individuals as well as groups o
Technical- Ability to use tools, techniques and processes that are
specific to the field o Conceptual-Ability to analyze complex
situations and respond effectively to challenges SCOPE OF
MANAGERIAL ECONOMICS - Demand analysis and forecasting Cost
analysis Production and supply analysis Pricing decisions, policies
and practices Profit management, and Capital management
CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS Managerial
economics is micro-economic in character Uses broadly theory of the
firm concepts Also seeks to apply profit theory which forms part of
distribution theories Is pragmatic as it avoids difficult abstract
issues of economic theory. But involves dealing with real life
complications of business world Belongs to normative economics
rather than positive economics. It is prescriptive rather than
descriptive. It involves judgment as to what is good/bad for
business. Managerial economics deals with which decision needs to
be made on the basis of its merits and demerits. Economic theory
does not go into judging decisions. Managerial economics tells what
the aims and objectives of a firm should be. Then it tells how best
these can be achieved Managerial economics is therefore described
as normative micro-economics of the firm Macro-economics is also
useful to managerial economics as it provides an intelligent
understanding of the environment in which the business must
operate. 6. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 6
RELATIONSHIP OF MANAGERIAL ECONOMICS WITH ECONOMICS, OPERATION
RESEARCH, DECISION MAKING, STATISTICS, ACCOUNTING ETC. STRATEGIC
MANAGEMENT ACCOUNTANCY MARKETING FINANCE INFORMATION ORGANIZATION
SYSTEMS BEHAVIOUR OPERATIONSRESEARCH HUMANRELATIONS ECONOMETRICS
ECONOMICS PSYCHOLOGY SOCIOLOGY RATE OFRETURN(HIGH)
RATEOFRETURN(LOW) TIMESPAN (LOW) TIMESPAN (HIGH) - MANAGEMENT =
ECONOMICS + PSYCHOLOGY (BROADER LEVEL OF UNDERSTANDING AS IS
PERCEIVED BY MOST INDIVIDUALS. THE BEDROCK IS FORMED FROM S O C I O
L O G Y) 7. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 7 UNIT
2 - FUNDAMENTAL CONCEPTS a. INCREMENTAL REASONING b. MARGINAL
ANALYSIS c. EQUIMARGINAL UTILITY d. TIME PERSPECTIVE e. CONSUMER
SURPLUS f. OPPORTUNITY COST g. TIME VALUE OF MONEY h. THEORIES OF
FIRM MANAGERIAL THEORIES BAUMOL AND WILLIAMSON BEHAVIORAL THEORIES
SIMON, CYRET AND MARCH INCREMENTAL REASONING - A Guide to Economic
Reasoning - Economic reasoning is making decisions by comparing
costs and benefits. Incremental reasoning is used in accepting or
rejecting a business proposition or option. Whenever a manager
takes a decision he asks the question Is it worthwhile? - The
implicit criterion is that incremental benefit should exceed its
incremental costs. Decision or action is worthwhile already if the
decision maker or the firm can expect to be better off than before.
Original reasoning forces the manager to examine the changes in
total revenues and total costs resulting for changes in production,
sales, price and related decisions. Wrong decisions may follow if
the focus is on the concept of average than on marginal analysis. 2
basics components of I.R are Incremental Cost Incremental Revenue
MARGINAL ANALYSIS o Marginal Costs and Marginal Benefits o The
relevant costs and benefits are the expected incremental, or
additional, costs incurred and the expected incremental benefits of
a decision. o Economist use the term marginal when referring to
additional or incremental. o Marginal cost the additional cost to
you over and above the costs you have already incurred. This means
not counting sunk costs costs that have already been incurred and
cannot be recovered. o Marginal benefit the additional benefit
above and beyond what youve already accrued. o According to the
economics decision rule: If the relevant benefits of doing
something exceed the relevant costs, do it. 8. P.S CHANDIRAMANI @
I.M.S , D.A.V.V, INDORE If the relevant costs of doing something
exceed the relevant benefits, dont Rs. Invested (Rs0000) A (Profit)
(Rs000) B (Profit) (Rs000 1 9 2 17 3 24 4 30 5 35 6 39 7 42 8 44 9
45 10 45 Utility Approach to Consumer Behavior Need for cardinal
measure of utility analysis is useful for explaining behavior Total
and Marginal utility law of diminishing Marginal Utility
Equimarginal rule and utility maximization Nature of Total Utility
- M.S , D.A.V.V, INDORE If the relevant costs of doing something
exceed the relevant benefits, dont do it. (Profit) (Rs000) A B
selection 4 - - A 8 8 4 A 12 7 4 A 16 6 4 A 20 5 4 A 24 4 4 A/B 28
3 4 B 32 2 4 B 36 1 4 B 40 0 4 B Utility Approach to Consumer
Behavior - Need for cardinal measure of utility ysis is useful for
explaining behavior Total and Marginal utility law of diminishing
Marginal Utility Equimarginal rule and utility maximization Page 8
If the relevant costs of doing something exceed the relevant
benefits, 9. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 9 When
more and more units of a good are consumed in a specific time
period, the utility derived tends to increase at a decreasing rate
Eventually, some maximum utility is derived and additional units
cause total utility to diminish. As an example, think of eating
free hot cakes. It is possible for total utility to initially
increase at an increasing rate. Marginal Utility Marginal utility
[MU] is the change in total utility associated with a 1 unit change
in consumption. As total utility increases at a decreasing rate, MU
declines. As total utility declines, MU is negative When TU is a
maximum, MU is 0 [This is sometimes called the Satiation point or
the point of absolute diminishing utility. Marginal Utility [MU] is
the change in total utility [TU] caused by a one unit change in
quantity [Q] ; MU = TU Q Utility Q 1 2 4 8 5 6 7 3 TU 30 55 75 90
100 105 105 100 MU The first unit consumed increases TU by 30. .
Remember that the MU is associated with the midpoint between the
units as each additional unit is added. 30 .25 Q The 2cd unit
increases TU by 25. 25 . 20 . 15 10 . 5 0 -5 1 2 3 4 5 6 7 Q/ut 10
20 30 MU . .. MU Fall 97 Principles of Microeconomics Slide -- 9 1
2 3 4 5 6 7 Q/ut 20 40 60 100 80 120 TU TU 1 2 3 4 5 6 7 Q/ut 10 20
30 MU The MU is the slope of TU or the rate of change in TU
associated with a one unit change in quantity. [Using calculus, MU
is the change in TU as change in quantity approaches 0.] The first
unit consumed, Q increases TU by 30, TU. Q . . . . . . . . TU For
the first unit: TU Q MU = = 1 30 The slope of TU is = 30, Q TU .
The second unit changes TU [ TU] by 25, The slope of TU between the
1 and second unit is 25. . between the 2cd and 3rd units TU = 20 or
the slope of TU is 20. . . . . . . MU MU is the slope of the TU.
Where MU = 0, TU is a maximum. max TU 10. P.S CHANDIRAMANI @ I.M.S
, D.A.V.V, INDORE Page 10 Consumer Preferences Both MU and TU are
determined by the preferences or utility function of the individual
and the quantity consumed. Utility cannot be measured directly but
individual choices reveal information about the individuals
preferences Surrogate variables [age, gender, ethnic background,
religion, etc.] may be correlated with preferences. There is a
tendency for TU to increase at a decreasing rate [MU declines] as
more of a good is consumed in a given time period: i.e. diminishing
marginal utility Diminishing Marginal Utility Initially, it may be
possible for TU to increase at an increasing rate. In which case MU
will increase [MU is the slope of TU which is increasing].
Eventually, as more and more of a good are consumed in a given time
period, TU continues to increase but at a decreasing rate; MU
decreases. This is called the point of diminishing marginal
utility. Law of Diminishing MU Notes about the Law of Diminishing
MU o Time period must be specified for law. o Law tells us that
eventually the marginal utility curve will be downward sloping. o
Law tells us that eventually the total utility curve will become
flatter. o Slope of the total utility curve is equal to marginal
utility Shape of MU Eventually downward sloping Law of diminishing
marginal utility Positive always Rational behavior Consumer only
purchases a good if they get some positive utility from it.
Consumer Choices If there were no costs associated with choices,
the individual will consume a good until MU = 0 [this maximizes TU
or the total benefits, TB] Typically, individuals are constrained
by a budget [or income] and the prices they pay for the goods they
consume. Net benefits are maximized where MB = MC; as long as the
MU or MB of the next unit of good purchased exceeds the Price or
MC, it will increase net benefits 11. P.S CHANDIRAMANI @ I.M.S ,
D.A.V.V, INDORE Page 11 Society and Individual The individual will
purchase more of a good so long as their perceived or anticipated
MB exceeds the price they must pay for the good: Buy so long as MB
> P, optimum where, P = MB From a social perspective that good
should only be produced and sold if the price is greater than or
equal to the MC: Sell so long as P > MC, optimum where P = MC
Social optimum when MB = P = MC LAW OF EQUI-MARGINAL UTILITY o The
Law of Equi-marginal utility is the further elaboration of the Law
of diminishing marginal utility. o It is also known as the Law of
Substitution and the Law of maximization of satisfaction. o The
households maximizing the utility will so allocate the expenditure
between commodities that the utility of the last penny spent on
each item is equal. o Formula for Consumers equilibrium MU(A)/P(A)
= MU(B)/P(B) = .= MU(N)/P(N) o Assumptions: Utilities are
independent Marginal utility of money remains constant. Utility is
cardinal. Consumer is rational. o Limitations.. Utility is
immeasurable. Indivisible goods Prices and tastes are changing.
Time Factor. 12. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 12
CONSUMER SURPLUS - Fall 97 Principles of Microeconomics Slide -- 31
1 2 3 4 5 6 7 QX/ut PX 1 2 3 4 5 6 7 Notice that someone is willing
and able to pay $6.80 for the first unit. 6.80 If the market price
[established by S and D] were $3, the buyer would purchase at $3
even though they were willing to pay $6.80 for the first unit. They
receive utility that they did not have to pay for [6.80-3.00]. This
is called consumer surplus. At market equilibrium, .Consumer
surplus will be the area above the market price and below the
demand function. consumer surplus CONSUMER SURPLUS OPPORTUNITY
COST- o The Opportunity cost of the chosen activity is the value of
the next-best alternative to the activity you have chosen. o
Opportunity cost is the basis of cost/benefit economic reasoning. o
In economic reasoning, opportunity cost must be less than the
benefit of what you have chosen. TIME VALUE OF MONEY - Present
value (PV) of an amount (FV) to be received at the end of n periods
when the per- period interest rate is i: ( ) PV FV i n= +1 13. P.S
CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 13 THEORIES OF FIRM o
Sales Maximization Model William Baumol According to the
sales-maximization model introduced by William Baumol and others,
managers of modern corporations seek to maximize sales after an
adequate rate of profit has been earned to satisfy stockholders.
Baumol argued that a larger firm may feel more secure, may be able
to get better deals in the purchase of inputs and lower rates in
borrowing money, and may have a better image with consumers,
employees, and suppliers. Indeed, some early empirical studies
found a strong correlation between executives salaries and sales,
but not between salaries and profits. More recent studies, however,
found the opposite. o Williamsons Model of Managerial Discretion
The managerial theory of firm developed by Oliver E. Williamson
states that managers apply discretion in making and implementing
policies to maximize their own utility rather than trying for the
maximization of profit which ultimately maximizes the utility of
owner shareholders. This is known as the management utility
maximization. It postulates that with the advent of the modern
corporation and the resulting separation of management from
ownership, managers are more interested in maximizing their
utility, measured in terms their compensation (salaries, fringe
benefits, stock options, etc.), the size of their staff, the extent
of control over the corporation, lavish offices, etc., than in
maximizing corporate profits. This is referred to as the
principal-agent problem. That is, the agent (manager) may be more
interested in maximizing his or her benefits than maximizing the
principals (the owners) interest. o Theory of Satisfying - Simon
The advocates of satisficing theory say that firms goal should be
satisficing rather than optimizing. Satisfying means acceptance of
less than the best. They argue that the behavior of real-world
managers is not always consistent with the profit-maximization
goal. Because of the great complexity of running the large modern
corporation a task often complicated by uncertainty and a lack of
adequate data managers are not able to maximize profits but can
only strive for some satisfactory goal in terms of sales, profits,
growth, market share, and so on. Simon called this satisficing
behavior. That is, the large corporation is a satisficing, rather
than a maximizing organization. o Cyert and Marchs Behavioral
Theory Cyert and March opined that a large-scale corporate type of
firm exists these days. Hence, entrepreneur cannot alone be a
decision maker. The decision- making involves a complex group or
organization. It consists of various individuals whose interest may
conflict with each other. 14. P.S CHANDIRAMANI @ I.M.S , D.A.V.V,
INDORE Page 14 The group is called organizational coalition and
includes managers, stockholders, workers, consumers and so on. All
of these individuals participate in setting the goals of an
organization. Unlike conventional theory of single goal, behavioral
theory states that an organization has multiple goals. The real
world firm generally possesses the following five goals: Production
Goal: According to this goal, production should not fluctuate too
much nor fall below an acceptable level. Because this ensures
stable employment, maintenance of adequate cost performance and
growth, the workers and those in production department have this
goal. Inventory Goal: This goal originates mainly from the
inventory department, or from the sales and production departments.
The sales department needs enough stock of output for the
customers, while the production department requires adequate stocks
of raw materials and other items necessary for a uniform flow of
the output. Sales Goal: The sales goal is simply an aspiration with
respect to the level of sales. Particularly, this goal arises from
salesmen, since their success depends on their ability to maintain
or expand the sales. Market-share Goal: This goal is an alternative
to the sales goal and arises from the sales department. This
department decides on the advertising campaigns, the market
research programmes, and so on. Profit Goal: This goal is set by
the top management in order to satisfy the demands of shareholders
and the expectations of bankers; and also to generate funds with
which they can achieve their own goals and projects, or satisfy the
other goals of the firm. While making decisions, firms are guided
by these five goals. The conflict among different goals may come
up. For example, sales goal may require a lower price whereas the
profit goal a higher price. Sales and production goal may require
high inventories whereas profit goal may require low inventories.
Such conflicts among coalition members are resolved within the firm
as a result of persuasion and accommodation of each others
viewpoint. The firm in the behavioral theories seeks to satisfice
overall performance, rather than maximize profits, sales or other
magnitudes. The firm is a satisficing organization rather than a
maximizing entrepreneur. The top management, accountable for the
coordination of the activities of the various members of the firm,
want: to attain a satisfactory level of production, to attain a
satisfactory share of the market, to earn a satisfactory level of
profit to divert a satisfactory percentage of their total receipts
to research and development or to advertising, 15. P.S CHANDIRAMANI
@ I.M.S , D.A.V.V, INDORE Page 15 to acquire a satisfactory public
image, and so on. But, it is not clear in the behavioral theories
what is a satisfactory and what an unsatisfactory attainment is.
Means for the Resolution of Conflicts: The top management uses
different methods to resolve the conflicts within the firm. The
means for the resolution of conflicts are: o delegation of
authority, o budget determination, o monetary payments like wages,
salary and dividend, o side payment given to the scientist of
research department in addition to regular salary, o slack payments
it is defined as payments to the various groups of the coalition
above than the payments required for efficient working of the firm.
o fulfilling demand according priority, o decentralization of
decision-making.
