MANAGERIAL ECONOMICS

UNIT-1,Contents- Definition of Managerial Economics - Nature and scope - Decision Making -

Fundamental Concepts Affecting Business Decisions - Incremental Concept - Marginalism –
Equi marginal Concept - the Time Perspective - Discounting Principle - Opportunity Cost
Principle - Utility Analysis.

DEFINITIONS OF ECONOMICS:
Several definitions of Economics have been given. For the sake of convenience let us classify the
various definitions into four groups:

1. Science of wealth
2. Science of material well-being
3. Science of choice making and
4. Science of dynamic growth and development .
WEALTH DEFINITION – Adam Smith
Economics as “an enquiry into the nature and causes of wealth”

MAIN FEATURES OF WEALTH DEFINITION

• Economics is concerned with the study of wealth only
• The term wealth denotes only material goods. Non-material goods like services and free
goods are excluded

• Economics studies the causes of wealth changes which means economic development

CRITICISM OF THE DEFINITION

1. Too much emphasis on wealth:

2. Restricted Meaning of Wealth:

3. No Mention of Man’s Welfare:

4. Economic Problem:
WELFARE DEFINITION – ALFRED MARSHALL

Economics is a study of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and with the
use of the material requisites of well being”.

FEATURES OF WELFARE DEFINITION

1. A study of mankind:

2. A study of social actions:

3. Study of Material Welfare:

4. Normative Science:

CRITICISM OF WELFARE DEFINITION

1. Material and Non-Material Welfare: Marshall has given more attention to the study of
material welfare alone. The services of teacher, lawyers, singers etc, do promote welfare
and such welfare may be termer as non-material welfare.

2. Objection to welfare: According to Robbins, there are certain material activities which
do not promote welfare. The manufacture of wine and opium are certainly economic
activities, but they are not conductive to human welfare.

3. Welfare cannot be measured: Marshall’s idea of welfare is based on cardinal utility.

But utility is a psychological entity which cannot be measured.
SCARCITY DEFINITION – prof. ROBBINS
“Economics is the science which studies human behavior as a relationship between ends and
scarce which have alternative uses”.

FUNDAMENTAL CHARACTERISTICS OF SCARCITY DEFINITION

1. Human wants are unlimited: “

2. Scarcity:

3. Alternative use of scare means:

4. The economic problem:

GROWTH DEFINITION – SAMUELSON
Economics is a social science mainly concerned with the way how society employs its limited
resources which have alternative uses, to produce goods and services for present and future
consumption of various people or groups.

MAIN FEATURES OF GROWTH DEFINITION:

1. It is applicable even in a batter economy where money measurement is not possible.
2. The inclusion of time element makes the scope of economics dynamics
3. This definition possesses universality in its applications.

Note: Growth definition is similar to scarcity definition and it is an improvement over the scarcity
definition.

DIVISION OF
ECONOMICS
Consumption
Production
Exchange
Distribution
Public Finance
ECONOMICS AS A SCIENCE
Science is a systematized body of knowledge which trades the relationship between cause
and effect. Robbins considered economics as a science and he explains that the last three
words of econom’ics’ indicate a clear proof that it is a science like Physics, Mathematics and
Dynamics.

ARGUMENT IN FAVOUR OF ECONOMICS AS A SCIENCE

The following arguments are advanced to consider economics as a science
1. Systematized study: The scientific method of study consists of three important steps a)

Observation

b) Reasoning, and

c) Verification

2. Scientific Law: A science is not a mere collection of facts, but establishes a relationship
between causes and effect.

3. Experiments: In physical sciences, experiments can be conducted in laboratories, in

economics, laboratory is the economy/society in which several laws and theories can be
tested.

4. Universal: The last requirement for a science is that its laws should be universal. In
economics also, the law of demand, law of diminishing returns etc. are universal in nature.
ECONOMICS AS AN ART
❖ According to J.N. Keyne’s “An art is a system of rules for the attainment of given end’.

❖ A science teaches us to know, an art teaches us to do –

❖ The systematic application of scientific principles is an art.

❖ Science requires art; art requires science, each being complementary to the other.
Thus economics is both a science and an art.
POSITIVE AND NORMATIVE APPROACHES

POSITIVE SCIENCE
A positive science is concerned with ‘what is’. It explains what it is, how it works and what
its effects are. According to Milton Friedman, positive economics deals as to how an
economic problem is solved.

ARGUMENTS IN FAVOUR OF POSITIVE SCIENCE

1. It is based on logic: Logical enquiry is a rational enquiry with help of logic, the relationship
between cause and effect can be ascertained.

2. It is based on the principles of specialization of labour: The modern economy is based on

division of labour. Each work is entrusted to a specialization group of workers.

NORMATIVE SCIENCE
Marshall, Fraser, wolf and Paul streeten are the main advocates of Normative science.
Normative science concerned with “what should be” or “What ought to be” Normative
science evaluates. According to Milton Friedman, normative science deals with how
economic problem should be solved.
ECONOMICS IS BOTH A POSITIVE AND A NORMATIVE SCIENCE
The modern economists accept that economics is both a positive science and a normative
science. They argue that optimum utilization of the resources would not be the only aim but
also the achievement of some desirable objective such as more and just distribution of
economic power and opportunities.

MANAGERIAL ECONOMICS – DEFINITION

Managerial Economics is a science which deals with the application of economic theory in
managerial practice. It is study of allocation of resources available to a firm among its activities.

Managerial economics as “the integration of economic theory with business practice for the
purpose of facilitating decision-making and forward planning by management –

Managerial economics makes use of analytical tools of economic theory in solving business
problems.
SCOPE OF THE MANAGERIAL ECONOMICS
1. Managerial Economics – Is it positive or normative:
Economics is divided into two categories, namely (1) Positive Economics and (2) Normative
Economics. Positive economics concerned with ‘what it is’, how it is work and what are its
effect.

While normative economics concerned with ‘what ought to be’ or ‘what should be’.. The
modern economists accepts that economics is both a positive science and normative science.

2. Area of study in Managerial Economics:

Broadly, Managerial economics deals with the following topics;

a. Demand analysis and forecasting
b. Cost and Production analysis
c. Pricing decision, policies and practices
d. Profit management
e. Capital Management
f. Linear programming and theory of games
3. Profit: the central concept in Managerial Economics:
CHARACTERISTICSOFMANAGERIAL ECONOMICS
The following characteristics of business economics will indicate its nature:
1. Micro economics:

2. Normative science:

3. Pragmatic: Managerial economics is pragmatic. It concentrates on making economic

theory more application oriented. It tries to solve the managerial problems in their day-today
functioning.

4. Prescriptive: Managerial economics is prescriptive rather than descriptive. It

prescribes solutions to various business problems.

5. Uses macro economics:. Macro economics provides an intelligent understanding of

the environment in which the business operates. economic policies of Government etc.

6. Management oriented:

7. Multi disciplinary:

8. Art and science.-

SIGNIFICANCE OF MANAGERIAL ECONOMICS
a. Maximization of profit
b. Theory of firm
c. Business accounting by accountant as different from economics
d. Estimating economic relationship i) price elasticity, ii) Income elasticity
e. Estimating economic quantities like demand, cost, capital etc.,
f. Predicting economic quantities in decision-making and forward planning.
DECISION-MAKING
• Decision-making is core aspect of managerial economics. Decision-making is the process
of selecting a particular course of action from among the various alternatives.

DIAGRAM OF PROCESS OF DECISION-MAKING

FUNDAMENTAL CONCEPTS AFFECTING BUSINESS DECISION

There are five fundamental concepts that affect the decision-making process;
I. Incremental concept
II. The concept of time perspective
III. The discounting principles
IV. The concept of opportunity cost V. The Equi-marginal principles

INCREMENTAL CONCEPT
The incremental concept involves the estimation of the impact of decision alternatives on cost
and revenues that result from changes in prices, products, procedures, investment, etc,.
Incremental concept is closely related to the marginal cost and marginal revenues of
economic theory. The two major concepts in this analysis are;
i) Incremental cost ii)
Incremental revenue
Incremental cost denotes changes in total cost whereas incremental revenue means change in total
revenue resulting from a decision of the firm.

A decision is profitable only if;

i) It increases revenue more than cost

ii) It decreases some costs more than it increases others

iii) It increases some revenues more than it decreases other

iv) It reduces costs more than revenues

Generally businessman holds the view that they ‘must make a profit on every job’ in order to
make an overall profit. With this concept, business may refuse orders that do not cover full
cost (variable cost and fixed cost) plus a provision of profit. This will leads to rejection of an
order which prevents short run profit.

The following example will illustrate this point.

Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000. the cost are
estimated as under;

Labour cost = Rs. 3000

Material cost = Rs. 4000
Overhead charges = Rs. 3600
Selling & Administrative cost = Rs. 1400
Full cost = Rs. 12,000

Then the other incremental cost is as follow;

Labour cost = Rs. 2000
Material cost = Rs. 4000
Overhead charges = Rs. 1000
Selling & Administrative cost = Nil
Incremental cost = Rs. 7,000
Thus there is a profit of Rs. 3000. The order can be accepted on the basis of incremental
reasoning. Incremental reasoning does not accept all orders at prices which cover merely their
incremental costs.

INCREMENTALISM AND MARGINALISM

• Incremental cost or revenue is similar to marginal cost or revenue concept. But there exist
some differences between incremental concept and marginal cost / revenue concepts.

• In the marginal analysis, marginal revenue means the addition made to the total revenue
by selling an additional or extra unit of the output.

• But incremental revenue simply measures the difference between the old and new
revenues. It is not restricted to the effects of a change in price, change in output. It measures
the impact of decision alternative on the total revenue.

THE CONCEPT OF TIME PERSPECTIVE

The time perspective concept states that the decision maker must give due consideration both
to the short run and long run effects of his decisions. He must give due emphasis to the various
time periods.

It was Alfred Marshall who introduced time element in economic theory.

Marshall explained four market forms based on time in economic theory i.e.,

1. Very Short Period: Very short period refers to the type of competitive market in
which the supply of commodities cannot be changed at all. So in a very short period,
the market supply is perfectly inelastic. The price of the commodity depends on the
demand for the product alone.

2. Short Period: Short period refers to that period in which supply can be adjusted to a
limited extent by varying the variable factors alone. the market supply is relatively
elastic.
3. Long Period: Long period is the time period during which the supply conditions are
fully able to meet the new demand conditions. In the long run, all (both fixed as well
as variable) factors are variable. the market supply is perfectly elastic.

4. Very long Period or Secular Period: The very long run is a situation where
technology and factors beyond the control of a firm can change significantly.

THE DISCOUNTING PRINCIPLES

• Discounting principles talks about the comparison of money value between present and
future time

• A rupee to be received tomorrow is worth less than a rupee today

• Whenever we make comparison between present and the future values of money, we always
discount future value to make it comparable with the present value.

• Example: Suppose there is a choice between receiving a gift of Rs. 1000/- today and
Rs.1000/- next year, naturally everyone would prefer Rs.1000/- today.

• Even though if there is a certainty of receiving Rs.1000/- next year, we choose to get
Rs.1000/- today, as it can yield some interest during one year by investing.
THE
CONCEPT OF OPPORTUNITY COST
➢ Both micro and macro economics make abundant use of the fundamental concept of
opportunity cost.

➢ In Managerial Economics, the opportunity cost concept is useful in decision involving a

choice between different alternative courses of action.

➢ Resources are scarce, we cannot produce all the commodities. For the production of one
commodity, we have to forego the production of another commodity.

➢ When you choose a particular alternative, the next best alternative must be given up. For
example, if you choose to watch cricket highlights in T.V., you must give up an extra hour
study.

➢ Thus the “opportunity cost” is the cost of something in terms of an opportunity forgone. In
other words, the opportunity cost of an action is the value of next best alternative forgone.

THE CONCEPT OF OPPORTUNITY COST INVOLVES THREE THINGS:

1. The calculation of opportunity cost involves the measurement of sacrifices.
2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed alternatives.

UTILITY ANALYSIS
1. Cardinal Approach
2. Ordinal Approach

CONCEPT OF UTILITY
UTILITY: Generally, Utility means “Usefulness”. In Economics, Utility is defined as the power
of a commodity or a service to satisfy the human wants.
TOTAL UTILITY: It refers to the sum of utilities of all units of a commodity consumed.
For example, if a person consumes ten apple, then the total utility is the sum of satisfaction
of consuming all the ten apple.

MARGINAL UTILITY: Marginal Utility is addition made to the total utility by consuming
one more unit of a commodity. Example: if a person consuming 10 apples, the marginal utility
is the utility derived from the 10th unit (or) last unit.

MUn=TUn-TUn-1

LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility explains an ordinary experience of a consumer. “If a
consumer takes more and more units of a same commodity, the additional utility he derives
from an extra unit of the commodity goes on falling”.

H.H.Gossen contributed initially and Alfred Marshall refined these idea as a law. This is also
called as Gossen’s First Law

ASSUMPTIONS OF THE LAW

a) The law holds good only when the process of consumption continues without anytime
gap.

b) The consumer’s taste, habit or preference must remain the same during the process of
consumption.

c) The income of the consumer remains constant.

d) The prices of the commodity consumed and its substitutes are constant.
e) The consumer is assumed to be a rational economic man. As a rational consumer, he
wants to maximise the total utility.

f) Utility is measurable.
g) All the units of the commodity must be identical in all aspects like taste, quality, colour
and size.

h) The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool drink
etc.

TABLE – TOTAL AND MARGINAL UTILITY SCHEDULE

Units of apple Total utility Marginal utility

1 20 20

2 35 15

3 45 10

4 50 5

5 50 0

6 45 -5

7 35 -10
DIAGRAM OF LAW OF MARGINAL UTILITY

1.

LIMITATION OF DMU
1. Utility is a psychological experience and it cannot be measured
2. This law based on single commodity consumption mode
3. According to the law, a consumer should consume continuously. But in real life it is not so.

4. The law assumes constancy of the marginal utility of money

5. A utility itself is capable of varying from person to person.

LAW OF EQUI-MARGINAL UTILITY

The idea of equi-marginal principles was first mentioned by H.H. Gossen. Hence it is called as
Gossen’s Second Law. Alfred Marshall made it as law. The law of equi-marginal utility explains
the behavior of a consumer when he consumes more than one commodity. It explains how the
consumer spends his limited income on various commodities to get maximum satisfaction. The
law also called “law of substitution or law of maximum satisfaction.

DEFINITION: “If a person has a thing which can be put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all”.
ASSUMPTIONS
a) The consumer is rational so he wants to get maximum satisfaction.
b) The utility of each commodity is measurable.
c) The marginal utility of money remains constant.
d) The income of the consumer is given.
e) The prices of the commodities are given.
f) The law is based on the law of diminishing marginal utility.

EXPLANATION OF THE LAW

Suppose a consumer wants to spend his limited income on Apple and Orange. He is said to
be in equilibrium, only when he gets maximum satisfaction with his limited income.
Therefore, he will be in equilibrium at the point where the utility derived from the last rupee
spent on each is equal.
LIMITATIONS OF THE LAW
• Indivisibility of Goods: The theory is weakened by the fact that many commodities like a
car, a house etc. are indivisible. In the case of indivisible goods, the law is not applicable.

• The Marginal Utility of Money is Not Constant: The theory is based on the assumption
that the marginal utility of money is constant. But that is not really so.

• The Measurement of Utility is not Possible: Utility is a subjective concept, which cannot
be measured, in quantitative terms.