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Managerial economics book

  1. 1. MANAGERIAL ECONOMICS MANAGERIAL ECONOMICS SYLLABUSUnit 1 Managerial economics: Meaning, nature and scope; Economic theory and managerial economic; Managerial economics and business decision making; Role of managerial economics.Unit 2 Demand Analysis: Meaning, types and determinants of demand.Unit 3 Cost Concepts: Cost function and cost output relationship; Economics and diseconomies of scale; Cost control and cost reduction.Unit 4 Production Functions: Pricing and output decisions under competitive conditions; Government control over pricing; Price discrimination; Price discount and differentials.Unit 5 Profit: Measurement of profit; Profit planning and forecasting; Profit maximization; Cost volume profit analysis; Investment analysis.Unit 6 National Income: Business cycle; Inflation and deflation; Balance of payment; Their implications in managerial decision. BABASAB PATIL (BEC DOMS )
  4. 4. MANAGERIAL ECONOMICS LESSON – 1 NATURE & SCOPE OF MANAGERIAL ECONOMICSThe terms Managerial Economics and Business Economics are oftenused interchangeably. However, the terms Managerial Economics hasbecome more popular and seems to displace Business Economics.DECISION-MAKING AND FORWARD PLANNINGThe chief function of a management executive in a business firm isdecision-making and forward planning. Decision-making refers to theprocess of selecting one action from two or more alternative coursesof action. Forward planning on the other hand is arranging plans forthe future. In the functioning of a firm the question of choice arisesbecause the available resources such as capital, land, labour andmanagement, are limited and can be employed in alternative uses. Thedecision-making function thus involves making choices or decisionsthat will provide the most efficient means of attaining anorganisational objectives, for example profit maximization. Once adecision is made about the particular goal to be achieved, plans for thefuture regarding production, pricing, capital, raw materials and labourare prepared. Forward planning thus goes hand in hand withdecision-making. The conditions in which firms work and takedecisions, is characterised with uncertainty. And this uncertainty notonly makes the function of decision-making and forward planningcomplicated but also adds a different dimension to it. If the knowledgeof the future were perfect, plans could be formulated without errorand hence without any need for subsequent revision. In the real world,however, the business manager rarely has complete information aboutthe future sales, costs, profits, capital conditions. etc. Hence, decisionsare made and plans are formulated on the basis of past data, currentinformation and the estimates about future that are predicted asaccurately as possible. While the plans are implemented over time, BABASAB PATIL (BEC DOMS )
  5. 5. MANAGERIAL ECONOMICSmore facts come into the knowledge of the businessman. Inaccordance with these facts the plans may have to be revised, and adifferent course of action needs to be adopted. Managers are thusengaged n a continuous process of decision-making through anuncertain future and the overall problem that they deal with isadjusting to uncertainty. To execute the function of ‘decision-making in an uncertainframe-work’, economic theory can be applied with considerableadvantage. Economic theory deals with a number of concepts andprinciples relating to profit, demand, cost, pricing, production,competition, business cycles and national income, which are aided byallied disciplines like accounting. Statistics and Mathematics also canbe used to solve or at least throw some light upon the problems ofbusiness management. The way economic analysis can be usedtowards solving business problems constitutes the subject matter ofManagerial Economics.DEFINITIONAccording to McNair the Merriam, Managerial Economics consists ofthe use of economic modes of thought to analyse business situations. Spencer and Siegelman have defined Managerial Economics as“the integration of economic theory with business practice for thepurpose of facilitating decision-making and forward planning bymanagement.” The above definitions suggest that Managerial economics is thediscipline, which deals with the application of economic theory tobusiness management. Managerial Economics thus lies on the marginbetween economics and business management and serves as thebridge between the two disciplines. The following Figure 1.1 shows therelationship between economics, business management andmanagerial economics. BABASAB PATIL (BEC DOMS )
  6. 6. MANAGERIAL ECONOMICSAPPLICATION OF ECONOMICS TO BUSINESS MANAGEMENTThe application of economics to business management or theintegration of economic theory with business practice, as Spencer andSiegelman have put it, has the following aspects : Reconciling traditional theoretical concepts of economics in relation to the actual business behavior and conditions: In economic theory, the technique of analysis is that of model building. This involves making some assumptions and, drawing conclusions on the basis of the assumptions about the behavior of the firms. The assumptions, however, make the theory of the firm unrealistic since it fails to provide a satisfactory explanation of what the firms actually do. Hence, there is need to reconcile the theoretical principles based on simplified assumptions with actual business practice and develop appropriate extensions and reformulation of economic theory. For example, it is usually assumed that firms aim at maximising profits. Based on this, the theory of the firm suggests how much the firm will produce and at what price it would sell. In practice, however, firms do not always aim at maximum profits (as they may think of diversifying or introducing new product etc.) To that extent, the theory of the firm fails to provide a satisfactory explanation of the firm’s actual behavior. Moreover, in actual business BABASAB PATIL (BEC DOMS )
  7. 7. MANAGERIAL ECONOMICSlanguage, certain terms like profits and costs have accountingconcepts as distinguished from economic concepts. Inmanagerial economics, an attempt is made to merge theaccounting concepts with the economics, an attempt is made tomerge the accounting concepts with the economic concepts.This helps in a more effective use of financial data related toprofits and costs to suit the needs of decision-making andforward planning.Estimating economic relationships: This involves themeasurement of various types of elasticities of demand such asprice elasticity, income elasticity, cross-elasticity, promotionalelasticity and cost-output relationships. The estimates of theseeconomic relationships are to be used for the purpose offorecasting.Predicting relevant economic quantities: Economic quantitiessuch as profit, demand, production, costs, pricing and capitalare predicated in numerical terms together with theirprobabilities. As the business manager has to work in anenvironment of uncertainty, the future needs to be foreseen sothat in the light of the predicted estimates, decision-making andforward planning may be possible.Using economic quantities in decision-making and forwardplanning: This involves formulating business policies forestablishing future business plans. This nature of economicforecasting indicates the degree of probability of variouspossible outcomes, i.e., losses or gains that will occur as a resultof following each one of the available strategies. Thus, aquantified picture gets set up, that indicates the number ofcourses open, their possible outcomes and the quantifiedprobability of each outcome. Keeping this picture in view, thebusiness manager is able to decide about which strategy shouldbe chosen. BABASAB PATIL (BEC DOMS )
  8. 8. MANAGERIAL ECONOMICS Understanding significant external forces: Applying economic theory to business management also involves understanding the important external forces that constitute the business environment and with which a business must adjust. Business cycles, fluctuations in national income and government policies pertaining to taxation, foreign trade, labour relations, antimonopoly measures, industrial licensing and price controls are typical examples. The business manager has to appraise the relevance and impact of these external forces in relation to the particular business unit and its business policies.CHARACTERISTICS OF MANAGERIAL ECONOMICSThere are certain chief characteristics of managerial economics, whichcan help to understand the nature of the subject matter and help in aclear understanding of the following terms: Managerial economics is micro-economic in character. This is because the unit of study is a firm and its problems. Managerial economics does not deal with the entire economy as a unit of study. Managerial economics largely uses that body of economic concepts and principles, which is known as Theory of the Firm or Economics of the Firm. In addition, it also seeks to apply profit theory, which forms part of distribution theories in economics. Managerial economics is concrete and realistic. I avoids difficult abstract issues of economic theory. But it also involves complications ignored in economic theory in order to face the overall situation in which decisions are made. Economic theory ignores the variety of backgrounds and training found in individual firms. Conversely, managerial economics is concerned BABASAB PATIL (BEC DOMS )
  9. 9. MANAGERIAL ECONOMICS more with the particular environment that influences decision-making. Managerial economics belongs to normative economics rather than positive economics. Normative economy is the branch of economics in which judgments about the desirability of various policies are made. Positive economics describes how the economy behaves and predicts how it might change. In other words, managerial economics is prescriptive rather than descriptive. It remains confined to descriptive hypothesis. Managerial economics also simplifies the relations among different variables without judging what is desirable or undesirable. For instance, the law of demand states that as price increases, demand goes down or vice-versa but this statement does not imply if the result is desirable or not. Managerial economics, however, is concerned with what decisions ought to be made and hence involves value judgments. This further has two aspects: first, it tells what aims and objectives a firm should pursue; and secondly, how best to achieve these aims in particular situations. Managerial economics, therefore, has been described as normative microeconomics of the firm. Macroeconomics is also useful to managerial economics since it provides an intelligent understanding of the business environment. This understanding enables a business executive to adjust with the external forces that are beyond the management’s control but which play a crucial role in the well being of the firm. The important forces are: business cycles, national income accounting, and economic policies of the government like those relating to taxation foreign trade, anti-monopoly measures and labour relations.DIFFFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICSThe difference between managerial economics and economics can beunderstood with the help of the following points: BABASAB PATIL (BEC DOMS )
  10. 10. MANAGERIAL ECONOMICSManagerial economics involves application of economicprinciples to the problems of a business firm whereas;economics deals with the study of these principles only.Economics ignores the application of economic principles to theproblems of a business firm.Managerial economics is micro-economic in character, however,Economics is both macro-economic and micro-economic.Managerial economics, though micro in character, deals onlywith a firm and has nothing to do with an individual’s economicproblems. But microeconomics as a branch of economics dealswith both economics of the individual as well as economics of afirm.Under microeconomics, the distribution theories, viz., wages,interest and profit, are also dealt with. Managerial economics onthe contrary is mainly concerned with profit theory and does notconsider other distribution theories. Thus, the scope ofeconomics is wider than that of managerial economics.Economic theory assumes economic relationships and buildseconomic models. Managerial economics adopts, modifies andreformulates the economic models to suit the specific conditionsand serves the specific problem solving process. Thus,economics gives the simplified model, whereas managerialeconomics modifies and enlarges it.Economics involves the study of certain assumptions like in thelaw of proportion where it is assumed that “The variable input asapplied, unit by unit is homogeneous or identical in amount andquality”. Managerial economics on the other hand, introducescertain feedbacks. These feedbacks are in the form of objectivesof the firm, multi-product nature of manufacture, behavioralconstraints, environmental aspects, legal constraints, constraintson resource availability, etc. Thus managerial economics,attempts to solve the complexities in real life, which areassumed in economics. this is done with the help of BABASAB PATIL (BEC DOMS )
  11. 11. MANAGERIAL ECONOMICS mathematics, statistics, econometrics, accounting, operations research, etc.OTHER TERMS FOR MANAGERIAL ECONOMICSCertain other expressions like economic analysis for businessdecisions and economics of business management have also beenused instead of managerial economics but they are not so popular.Sometimes expressions like ‘Economics of the Enterprise’, ‘Theory ofthe Firm’ or ‘Economics of the Firm’ have also been used formanagerial economics. It is, however, not appropriate t use thesesterms because managerial economics, though primarily related to theeconomics of the firm, differs from it in the following respects: First, ‘Economics of the Firm’ deals with the theory of the firm, which is a body of economic principles relating to the firm alone. Managerial economics on the other hand deals with the, application of the same principles to business. Secondly, the term ‘Economics of the firm’ is too simple in its assumptions whereas managerial economics has to reckon with actual business behaviour, which is much more complex.SCOPE OF MANAGERIAL ECONOMICSAs regards the scope of managerial economics, there is no generaluniform pattern. However, the following aspects may be said to beinclusive under managerial economics: Demand analysis and forecasting. Cost and production analysis. Pricing decisions, policies and practices. Profit management. Capital management. These aspects may also be defined as the ‘Subject-Matter ofManagerial Economics’. In recent years, there is a trend towardsintegrations of managerial economics and operations research. Hence, BABASAB PATIL (BEC DOMS )
  12. 12. MANAGERIAL ECONOMICStechniques such as linear programming, inventory models and theoryof games have also been regarded as a part of managerial economics.Demand Analysis and ForecastingA business firm is an economic Organisation, which transformsproductive resources into goods that are to be sold in a market. Amajor part of managerial decision-making depends on accurateestimates of demand. This is because before production schedules canbe prepared and resources are employed, a forecast of future sales isessential. This forecast can also guide the management in maintainingor strengthening the market position and enlarging profits. Thedemand analysis helps to identify the various factors influencingdemand for a firm’s product and thus provides guidelines tomanipulate demand. Demand analysis and forecasting, thus, isessential for business planning and occupies a strategic place inmanagerial economics. It comprises of discovering the forcesdetermining sales and their measurement. The chief topics covered inthis are: Demand determinants Demand distinctions Demand forecasting.Cost and Production AnalysisA study of economic costs, combined with the data drawn from thefirm’s accounting records, can yield significant cost estimates. Theseestimates are useful for management decisions. The factors causingvariations in costs must be recognised and thereby should be used fortaking management decisions. This facilitates the management toarrive at cost estimates, which are significant for planning purposes.An element of cost uncertainty exists in this because all the factorsdetermining costs are not always known or controllable. Therefore, itis essential to discover economic costs and measure them for effectiveprofit planning, cost control and sound pricing practices. Production BABASAB PATIL (BEC DOMS )
  13. 13. MANAGERIAL ECONOMICSanalysis is narrower in scope than cost analysis. The chief topicscovered under cost and production analysis are: Cost concepts and classifications Cost-output relationships Economics of scale Production functions Cost control.Pricing Decisions, Policies and PracticesPricing is a very important area of managerial economics. In fact priceis the origin of the revenue of a firm. As such the success of a usinessfirm largely depends on the accuracy of price decisions of that firm.The important aspects dealt under area, are as follows: Price determination in various market forms Pricing methods Differential pricing product-line pricing and price forecasting.Profit ManagementBusiness firms are generally organised with the purpose of makingprofits. In the long run, profits provide the chief measure of success.In this connection, an important point worth considering is theelement of uncertainty existing about profits. This uncertainty occursbecause of variations in costs and revenues. These are caused byfactors such as internal and external. If knowledge about the futurewere perfect, profit analysis would have been a very easy task.However, in a world of uncertainty, expectations are not alwaysrealised. Thus profit planning and measurement make up the difficultarea of managerial economics. The important aspects covered underthis area are: Nature and measurement of profit. Profit policies and techniques of profit planning.Capital ManagementAmong the various types and classes of business problems, the mostcomplex and troublesome for the business manager are those relatingto the firm’s capital investments. Capital management implies BABASAB PATIL (BEC DOMS )
  14. 14. MANAGERIAL ECONOMICSplanning and control and capital expenditure. In this procedure,relatively large sums are involved and the problems are so complexthat their disposal not only requires considerable time and labour butalso top-level decisions. The main elements dealt with costmanagement are: Cost of capital Rate of return and selection of projects. The various aspects outlined above represent the majoruncertainties, which a business firm has to consider viz., demanduncertainty, cost uncertainty, price uncertainty, profit uncertainty andcapital uncertainty. We can, therefore, conclude that managerialeconomics is mainly concerned with applying economic principles andconcepts to adjust with the various uncertainties faced by a businessfirm.MANAGERIAL ECONOMICS AND OTHER SUBJECTSYet another useful method of explaining the nature and scope ofmanagerial economics is to examine its relationship with othersubjects. The following discussion helps to understand relationshipbetween managerial economics and economics, statistics, mathematics,accounting and operations research.Managerial Economics and EconomicsManagerial economics is defined as a subdivision of economics thatdeals with decision-making. It may be viewed as a special branch ofeconomics bridging the gulf between pure economic theory andmanagerial practice. Economics has two maindivisions-microeconomics and Macroeconomics. Microeconomics hasbeen defined as that branch where the unit of study is an individual ora firm. It is also called “price theory” (or Marshallian economics) and isthe main source of concepts and analytical tools for managerialeconomics. To illustrate, various micro-economic concepts such aselasticity of demand, marginal cost, the short and the long runs, BABASAB PATIL (BEC DOMS )
  15. 15. MANAGERIAL ECONOMICSvarious market forms, etc., are all of great significance to managerialeconomics. Macroeconomics, on the other hand, is aggregative in characterand has the entire economy as a unit of study. The chief contributionof macroeconomics to managerial economics is in the area offorecasting. The modern theory of income and employment has directimplications for forecasting general business conditions. As theprospects of an individual firm often depend greatly on generalbusiness conditions, individual firm forecasts rely on general businessforecasts. A survey in the U.K. has shown that business economists havefound the following economic concepts quite useful and of frequentapplication: Price elasticity of demand Income elasticity of demand Opportunity cost Multiplier Propensity to consume Marginal revenue product Speculative motive Production function Liquidity preference Business economists have also found the following main areas of economics as useful in their work. Demand theory Theory of firms – price, output and investment decisions Business financing Public finance and fiscal policy Money and banking National income and social accounting Theory of international trade Economies of developing countries. Thus, it is obvious that Managerial Economics is very closelyrelated to Economics. BABASAB PATIL (BEC DOMS )
  16. 16. MANAGERIAL ECONOMICSManagerial Economics and StatisticsStatistics is important to managerial economics in several ways.Managerial economics calls for the organising quantitative data andderiving a useful measure of appropriate functional relationshipsinvolved in decision-making. For instance, in order to base its pricingdecisions on demand and cost considerations, a firm should havestatistically derived or calculated demand and cost functions.Managerial economics also employs statistical methods forexperimental testing of economic generalisations. The generalisationscan be accepted in practice only when they are checked against thedata from the world of reality and are found valid. Managers do nothave exact information about the variables affecting decisions andhave to deal with the uncertainty of future events. The theory ofprobability, upon which statistics is based, provides logic for dealingwith such uncertainties.Managerial Economics and MathematicsMathematics is yet another important subject closely related tomanagerial economics. This is because managerial economics ismathematical in character, as it involves estimating various economicrelationships, predicting relevant economic quantities and using themin decision-making and forward planning. Knowledge of geometry,trigonometry ad algebra is not only essential but also certainmathematical tools and concepts such as logarithms and exponential,vectors, determinants, matrix, algebra, calculus, differential as well asintegral, are the most commonly used devices. Further, operationsresearch, which is closely related to managerial economics, ismathematical in character. It provides and analyses data ad developsmodels, benefiting from the experiences of experts drawn fromdifferent disciplines, viz., psychology, sociology, statistics andengineering. BABASAB PATIL (BEC DOMS )
  17. 17. MANAGERIAL ECONOMICSMANAGERIAL ECONOMICS AND ACCOUNTINGManagerial economics is also closely related to accounting, which isconcerned with recording the financial operations of a business firm.In fact, a managerial economist depends chiefly on the accountinginformation as an important source of data required for hisdecision-making purpose. for instance, the profit and loss statementof a firm shows how well the firm has done and whether theinformation it contains can be used by managerial economist to throwsignificant light on the future course of action that is whether the firmshould improve its productivity or close down. Therefore, accountingdata require careful interpretation, reconstruction and adjustmentsbefore they can be used safely and effectively. It is in this context thatthe link between management accounting and managerial economicsdeserves special mention. The main task of management accounting isto provide the sort of data, which managers need if they are to applythe ideas of managerial economics to solve business problemscorrectly. The accounting data should be provided in such a form thatthey fit easily into the concepts and analysis of managerial economics.Managerial Economics and Operations ResearchOperations research is a subject field that emerged during the SecondWorld War and the years thereafter. A good deal of interdisciplinaryresearch was done in the USA. as well as other western countries tosolve the complex operational problems of planning and resourceallocation in defence and basic industries. Several experts likemathematicians, statisticians, engineers and others teamed uptogether and developed models and analytical tools leading to theemergence of this specialised subject. Much of the development oftechniques and concepts, such as linear programming, inventorymodels, game theory, etc., emerged from the working of the operationresearchers. Several problems of managerial economics are solved bythe operation research techniques. These highlight the significant BABASAB PATIL (BEC DOMS )
  18. 18. MANAGERIAL ECONOMICSrelationship between managerial economics and operations research.The problems solved by operation research are as follows: Allocation problems: An allocation problem confronts with the issue that men, machines and other resources are scarce, related to the number sand size of the jobs that need to be completed. The examples are production programming and transportation problems. Competitive problems: competitive problems deal with situations where managerial decision-making is to be made in the face of competitive action. That is, one of the factors to be considered is: “What will competitors do if certain steps are taken?” Price reduction, for example, will not lead to increased market share if rivals follow suit. Waiting line problems : Waiting line problems arise when a firm wants to know how many machines it should install in order to ensure that the amount of ‘work-in-progress’ waiting to be machined is neither too small nor too large. Such situations arise when for example, a post office, or a bank wants to know how many cash desks or counter clerks it should employ in order to balance the business lost through long guesses against the cost of installing more equipment or hiring more labour. Inventory problems: Inventory problems deal with the principal question: “What is the optimum level of stocks of raw-materials, components or finished goods for the firm to hold?” The above discussion explains that the managerial economics isclosely related to certain subjects such as economics, statistics,mathematics and accounting. A trained managerial economistcombines concepts and methods from all these subjects by bringingthem together to solve business problems. In particular, operationsresearch and management accounting are getting very close tomanagerial economics.USES OF MANAGERIAL ECONOMICS BABASAB PATIL (BEC DOMS )
  19. 19. MANAGERIAL ECONOMICSManagerial economics achieves several objectives. The principalobjectives are as follows: It presents those aspects of traditional economics, which are relevant for business decision-making in real life. For this purpose, it picks from economic theory those concepts, principles and techniques of analysis, which are concerned with the decision-making process. These are adapted or modified in such a way that it enables the manager to take better decisions. Thus, managerial economics attains the objective of building a suitable tool kit from traditional economics. Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc. If they are found relevant for decision-making. In fact, managerial economics takes the aid of other academic disciplines that are concerned with the business decisions of a manager in view of the various explicit and implicit constraints subject to which resource allocation is to be optimised. It helps in reaching a variety of business decisions even in a complicated environment. Certain examples of such decisions are those decisions concerned with: o The products and services to be produced o The inputs and production techniques to be used o The quantity of output to be produced and the selling prices to be subscribed o The best sizes and locations of new plants o Time of replacing the equipment o Allocation of the available capital Managerial economics helps a manager to become a more competent model builder. Thus, he can pick out the essential relationships, which characterise a situation and leave out the other unwanted details and minor relationships. At the level of the firm, functional specialists or functional departments exist, e.g., finance, marketing, personnel, BABASAB PATIL (BEC DOMS )
  20. 20. MANAGERIAL ECONOMICS production etc. For these various functional areas, managerial economics serves as an integrating agent by co-ordinating the different areas. It then applies the decisions of each department or specialist, those implications, which are pertaining to other functional areas. Thus managerial economics enables business decision-making to operate not with an inflexible and rigid but with an integrated perspective. This integration is important because the functional departments or specialists often enjoy considerable autonomy and achieve conflicting goals.Managerial economics keeps in mind the interaction between the firm and society and accomplishes the key role of business as an agent in attaining social economic welfare. There is a growing awareness that besides its obligations to shareholders, business enterprise has certain social obligations as well. Managerial economics focuses on these social obligations while taking business decisions. By doing so, it serves as an instrument of furthering the economic welfare of the society through socially oriented business decisions. Thus, it is evident that the applicability and usefulness ofmanagerial economics is obtained by performing the followingactivates: Borrowing and adopting the tool-kit from economic theory. Incorporating relevant ideas from other disciplines to achieve better business decisions. Serving as a catalytic agent in the course of decision-making by different functional departments/specialists at the firm’s level. Accomplishing a social purpose by adjusting business decisions to social obligations.ECONOMIC THEORY AND MANAGERIAL ECONOMICSEconomic theory offers a variety of concepts and analytical tools thatcan assist the manager in the decision-making practices. Problemsolving in business has, however, found that there exists a wide BABASAB PATIL (BEC DOMS )
  21. 21. MANAGERIAL ECONOMICSdisparity between the economic theory of a firm and actual observedpractice, thus necessitating the use of many skills and be quite usefulto examine two aspects in this regard: The basic tools of managerial economics which it has borrowed from economics, and The nature and extent of gap between the economic theory of the firm and the managerial theory of the firm.Basic Economic Tools in Managerial EconomicsThe most significant contribution of economics to managerialeconomics lies in certain principles, which are basic to the entire rangeof managerial economics. The basic principles may be identified asfollows:1. Opportunity Cost PrincipleThe opportunity cost of a decision means the sacrifice of alternativesrequired by that decision. This can be best understood with the help ofa few illustrations, which are as follows: The opportunity cost of the funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures. The opportunity cost of the time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment. The opportunity cost of using a machine to produce one product is equal to the earnings forgone which would have been possible from other products. The opportunity cost of using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities. If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 BABASAB PATIL (BEC DOMS )
  22. 22. MANAGERIAL ECONOMICS units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y. If no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py. The opportunity cost of holding Rs. 500 as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil. For decision-making, opportunity costs are the only relevantcosts. The opportunity cost principle may be stated as under: “The cost involved in any decision consists of the sacrifices ofalternatives required by that decision. If there are no sacrifices, thereis no cost.” Thus in macro sense, the opportunity cost of more guns in aneconomy is less butter. That is the expenditure to national fund forbuying armour has cost the nation of losing an opportunity of buyingmore butter. Similarly, a continued diversion of funds towards defencespending, amounts to a heavy tax on alternative spending required forgrowth and development.2. Incremental PrincipleThe incremental concept is closely related to the marginal costs andmarginal revenues of economic theory. Incremental concept involvestwo important activities which are as follows: Estimating the impact of decision alternatives on costs and revenues. Emphasising the changes in total cost and total cost and total revenue resulting from changes in prices, products, procedures, investments or whatever may be at stake in the decision. The two basic components of incremental reasoning are as follows: BABASAB PATIL (BEC DOMS )
  23. 23. MANAGERIAL ECONOMICS Incremental cost: Incremental cost may be defined as the change in total cost resulting from a particular decision. Incremental revenue: Incremental revenue means the change in total revenue resulting from a particular decision.The incremental principle may be stated as under: A decision is obviously a profitable one if: o It increases revenue more than costs o It decreases some costs to a greater extent than it increases other costs o It increases some revenues more than it decreases other revenues o It reduces costs more that revenues. Some businessmen hold the view that to make an overall profit,they must make a profit on every job. Consequently, they refuseorders that do not cover full cost (labour, materials and overhead) plusa provision for profit. Incremental reasoning indicates that this rulemay be inconsistent with profit maximisation in the short run. Arefusal to accept business below full cost may mean rejection of apossibility of adding more to revenue than cost. The relevant cost isnot the full cost but rather the incremental cost. A simple problem willillustrate this point.IIIustrationSuppose a new order is estimated to bring in additional revenue of Rs.5,000. The costs are estimated as under: Labour Rs. 1,500 Material Rs. 2,000 Overhead (Allocated at 120% of labour cost) Rs. 1,800 Selling administrative expenses (Allocated at 20% of labour and material cost) Rs. 700 Total Cost Rs. 6,000 The order at first appears to be unprofitable. However, suppose,if there is idle capacity, which can be, utilised to execute this order BABASAB PATIL (BEC DOMS )
  24. 24. MANAGERIAL ECONOMICSthen the order can be accepted. If the order adds only Rs. 500 ofoverhead (that is, the added use of heat, power and light, the addedwear and tear on machinery, the added costs of supervision, and soon), Rs. 1,000 by way of labour cost because some of the idle workersalready on the payroll will be deployed without added pay and no extraselling and administrative cost then the incremental cost of acceptingthe order will be as follows. Labour Rs. 1,500 Material Rs. 2,000 Overhead Rs. 500 Total Incremental Cost Rs. 3,500 While it appeared in the first instance that the order will result ina loss of Rs. 1,000, it now appears that it will lead to an addition of Rs.1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does notmean that the firm should accept all orders at prices, which covermerely their incremental costs. The acceptance of the Rs. 5,000 orderdepends upon the existence of idle capacity and labour that would gounutilised in the absence of more profitable opportunities. Earley’sstudy of “excellently managed” large firms suggests that progressivecorporations do make formal use of incremental analysis. It is,however, impossible to generalise on the use of incremental principle,since the observed behaviour is variable.3. Principle of Time PerspectiveThe economic concepts of the long run and the short run have becomepart of everyday language. Managerial economists are also concernedwith the short-run and long-run effects of decisions on revenues aswell as on costs. The actual problem in decision-making is to maintainthe right balance between the long-run and short-run considerations.A decision may be made on the basis of short-run considerations, butmay in the course of time offer long-run repercussions, which make it BABASAB PATIL (BEC DOMS )
  25. 25. MANAGERIAL ECONOMICSmore or less profitable than it appeared at first. An illustration willmake this point clear.IIIustrationSuppose there is a firm with temporary idle capacity. An order for5,000 units comes to management’s attention. The customer is willingto pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.The short-run incremental cost (ignoring the fixed cost) is only Rs.3.00. Therefore, the contribution to overhead and profit is Re. 1.00 perunit (Rs. 5,000 for the lot. However, the long-run repercussions of theorder ought to be taken into account are as follows: If the management commits itself with too much of business at lower prices or with a small contribution, it may not have sufficient capacity to take up business with higher contributions when the opportunity arises. The management may be compelled to consider the question of expansion of capacity and in such cases; even the so-called fixed costs may become variable. If any particular set of customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated. In response, they may opt to patronise manufacturers with more decent views on pricing. The reduction or prices under conditions of excess capacity may adversely affect the image of the company in the minds of its clientele, which will in turn affect its sales. It is, therefore, important to give due consideration to the timeperspective. The principle of time perspective may be stated as under:‘A decision should take into account both the short-run and long-runeffects on revenues and costs and maintain the right balance betweenthe long-run and short-run perspectives.” Haynes, Mote and Paul have cited the case of a printing company.This company pursued the policy of never quoting prices below full BABASAB PATIL (BEC DOMS )
  26. 26. MANAGERIAL ECONOMICScost though it often experienced idle capacity and the managementwas fully aware that the incremental cost was far below full cost. Thiswas because the management realised that the long-run repercussionsof pricing below full cost would make up for any short-run gain. Themanagement felt that the reduction in rates for some customers mighthave an undesirable effect on customer goodwill particularly amongregular customers not benefiting from price reductions. It wanted toavoid crating such an “image” of the firm that it exploited the marketwhen demand was favorable but which was willing to negotiate pricesdownward when demand was unfavorable.4. Discounting PrincipleOne of the fundamental ideas in economics is that a rupee tomorrow isworth less than a rupee today. This seems similar to the saying that abird in hand is worth two in the bush. A simple example would makethis point clear. Suppose a person is offered a choice to make betweena gift of Rs. 100 today or Rs. 100 next year. Naturally he will choosethe Rs. 100 today. This is true for two reasons. First, the future is uncertain andthere may be uncertainty in getting Rs. 100 if the present opportunityis not availed of. Secondly, even if he is sure to receive the gift infuture, today’s Rs. 100 can be invested so as to earn interest, say, at 8percent so that. one year after the Rs. 100 of today will become Rs.108 whereas if he does not accept Rs. 100 today, he will get Rs. 100only in the next year. Naturally, he would prefer the first alternativebecause he is likely to gain by Rs. 8 in future. Another way of sayingthe same thing is that the value of Rs. 100 after one year is not equalto the value of Rs. 100 of today but less than that. To find out howmuch money today is equal to Rs. 100 would earn if one decides toinvest the money. Suppose the rate of interest is 8 percent. Then weshall have to discount Rs. 100 at 8 per cent in order to ascertain howmuch money today will become Rs. 100 one year after. The formula is: Rs. 100 V= 1+i BABASAB PATIL (BEC DOMS )
  27. 27. MANAGERIAL ECONOMICS where, V = present value i = rate of interest. Now, applying the formula, we get Rs. 100 V= 1+i 100 = 1.08 If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,which will accumulate at 8 per cent after one year. 92.59 x 1.08 = 99.0072 = 1.00 The same reasoning applies to longer periods. A sum of Rs. 100two years from now is worth: Rs. 100 Rs. 100 Rs. 100 V= (1+i)2 = (1.08)2 = 1.1664 Similarly, we can also check by computing how much thecumulative interest will be after two years. The principle involved inthe above discussion is called the discounting principle and is statedas follows: “If a decision affects costs and revenues at future dates, itis necessary to discount those costs and revenues to present valuesbefore a valid comparison of alternatives is possible.”5. Equi-marginal PrincipleThis principle deals with the allocation of the available resource amongthe alternative activities. According to this principle, an input shouldbe allocated in such a way that the value added by the last unit is thesame in all cases. This generalisation is called the equi-marginalprinciple. Suppose a firm has 100 units of labour at its disposal. The firmis engaged in four activities, which need labour services, viz., A, B, C BABASAB PATIL (BEC DOMS )
  28. 28. MANAGERIAL ECONOMICSand D. It can enhance any one of these activities by adding morelabour but sacrificing in return the cost of other activities. If the valueof the marginal product is higher in one activity than another, then itshould be assumed that an optimum allocation has not been attained.Hence it would, be profitable to shift labour from low marginal valueactivity to high marginal value activity, thus increasing the total valueof all products taken together. For example, if the values of certaintwo activities are as follows: Value of Marginal Product of labour Activity A = Rs. 20 Activity B = Rs. 30 In this case it will be profitable to shift labour from A to activityB thereby expanding activity B and reducing activity A. The optimumwill be reach when the value of the marginal product is equal in all thefour activities or, when in symbolic terms: VMPLA = VMPLB = VMPLC = VMPLD Where the subscripts indicate labour in respective activities. Certain aspects of the equi-marginal principle need clarifications,which are as follows: First, the values of marginal products are net of incremental costs. In activity B, we may add one unit of labour with an increase in physical output of 100 units. Each unit is worth 50 paise so that the 100 units will sell for Rs. 50. But the increased output consumes raw materials, fuel and other inputs so that variable costs in activity B (not counting the labour cost) are higher. Let us say that the incremental costs are Rs. 30 leaving a net addition of Rs. 20. The value of the marginal product relevant for our purpose is thus Rs. 20. Secondly, if the revenues resulting from the addition of labour are to occur in future, these revenues should be discounted before comparisons in the alternative activities are possible. Activity A may produce revenue immediately but activities B, C BABASAB PATIL (BEC DOMS )
  29. 29. MANAGERIAL ECONOMICS and D may take 2, 3 and 5 years respectively. Here the discounting of these revenues will make them equivalent. Thirdly, the measurement of value of the marginal product may have to be corrected if the expansion of an activity requires an alternative reduction in the prices of the output. If activity B represents the production of radios and it is not possible to sell more radios without a reduction in price, it is necessary to make adjustment for the fall in price. Fourthly, the equi-marginal principle may break under sociological pressures. For instance, du to inertia, activities are continued simply because they exist. Similarly, due to their empire building ambitions, managers may keep on expanding activities to fulfil their desire for power. Department, which are already over-budgeted often, use some of their excess resources to build up propaganda machines (public relations offices) to win additional support. Governmental agencies are more prone to bureaucratic self-perpetuation and inertia.Gaps between Theory of the Firm and managerial EconomicsThe theory of the firm is a body of theory, which contains certainassumptions, theorems and conclusions. These theorems deal with theway in which businessmen make decisions about pricing, andproduction under prescribed market conditions. It is concerned withthe study of the optimisation process. For optimality to exist profit must be maximised and this canoccur only when marginal cost equals marginal revenue. Thus, theoptimum position of the firm is that which maximises net revenue.Managerial economics, on the other hand, aims at developing amanagerial theory of the firm and for the purpose it takes the help ofeconomic theory of the firm. However, there are certain difficulties inusing economic theory as an aid to the study of decision-making atthe level of the firm. This is because for the purposes of business BABASAB PATIL (BEC DOMS )
  30. 30. MANAGERIAL ECONOMICSdecision-making it fails to provide sufficient analytical tools that areuseful to managers. Some of the reasons are as follows: Underlying all economic theory is the assumption that the decision-maker is omniscient and rational or simply that he is an economic man. Thus being omniscient means that he knows the alternatives that are available to him as well as the outcome of any action he chooses. The model of “economic man” however as an omniscient person who is confronted with a compete set of known or probabilistic outcomes is a distorted representation of reality. The typical business decision-maker usually has limited information at his disposal, limited computing ability and a limited number of feasible alternatives involving varying degrees of risk. Further, the net revenue function, which he is expected to maximise, and the marginal cost and marginal revenue functions, which he is expected to equate, require excessive knowledge of information, which is not known and cannot be obtained even by the most careful analysis. Hence, it is absurd to expect a manager to maximise and equalise certain critical functional relationships, which he does not know and cannot find out. In micro-economic theory, the most profitable output is where marginal cost (MC) and marginal revenue (MR) are equal. In Figure 1.2, the most profitable output will be at ON where MR=MC. This is the point at which the slope of the profit function or marginal profit is zero. This is highlighted in Figure 1.3 where the most profitable output will be again at ON. In economic theory, the decision-maker has to identify this unique output level, which maximises profit. BABASAB PATIL (BEC DOMS )
  31. 31. MANAGERIAL ECONOMICS In real world, however, a complexity often arises, viz., certainresource limitations exist. As a result, it is not possible to attain themaximum output level (ON). In practical terms the maximum outputpossible as a result of resource limitations is, say, OM. Now theproblem before the decision-maker is to find out whether the output,which maximises profit, is OM or some other level of output to the leftof OM. It is obvious that economic theory is of no help for ON level ofoutput because it is not relevant in view of the resource limitations. Amanagerial economist here has to take the aid of linear programming,which enables the manager to optimise or search for the best valueswithin the limits set by inequality conditions. Another central assumption in the economic theory of the firm is that the entrepreneur strives to maximise his residual share, or profit. Several criticisms of this assumption have been made: BABASAB PATIL (BEC DOMS )
  32. 32. MANAGERIAL ECONOMICSo The theory is ambiguous, as it doesn’t clarify. Whether it is short or long run profit that is to be maximised. For example, in the short run, profits could be maximised by firing all research and development personnel and thereby eliminating considerable immediate expenses. This decision would, however, have a substantial impact on long-run profitability.o Certain questions create some confusion around the concept of profit maximisation. Should the firm seek to maximise the amount of profit or the rate of profit? What is the rate of profit? Is it profit in relation to total capital or profit in relation to shareholders’ equity?o There is no allowance for the existence of “psychic income” (Income other than monetary, power, prestige, or fame), which the entrepreneur might obtain from the firm, quite apart from his monetary income.o The theory does not recognise that under modern conditions, owners and managers are separate and distinct groups of people and the latter may not be motivated to maximise profits.o Under imperfect competition, maximisation is an ambiguous goal, because actions that are optimal for one will depend on the actions of the other firms.o The entrepreneur may not care to receive maximum profits but may simply want to earn “satisfactory profits”. This last point is particularly relevant from the behavioural science standpoint because it introduces a concept of satiation. The notion of satiation plays no role in classical economic theory. To explain business behaviour in terms of this theory, it is necessary to assume that the firm’s goals are not concerned with maximising profit, but with attaining a certain level or rate of profit, holding a certain share of the market or a BABASAB PATIL (BEC DOMS )
  33. 33. MANAGERIAL ECONOMICS certain level of sales. Firms would try to satisfy rather than maximise. But according to Simon the satisfying model damages all the conclusions that can be derived concerning resource allocation under perfect competition. It focuses on the fact that the classical theory of the firm is empirically incorrect as a description of the decision-making process. Based on this notion of satiation, it appears that one of the main strengths of classical economic theory has been seriously weakened.Most corporate undertakings involve the investment of funds,which are expect to produce revenues over a number of years.The profit maximisation criterion provides no basis forcomparing alternatives that can promise varying flows ofrevenue and expenditure over time.The practical application of profit maximisation concept alsohas another limitation. It provides no explicit way ofconsidering the risk associated with alternative decisions.Two projects generating similar expected revenues in thefuture and requiring similar outlays might differ vastly asregarding the degree of uncertainty with which the benefitsto be generated. The greater the uncertainty associated withthe benefits, the greater the risk associated with the project.Baumol on the other hand is of the view that firms do notdevote all their energies to maximising profit. Rather acompany will seek to maximise its sales revenue as long as asatisfactory level of profit is maintained. Thus Baumol hassubstituted “Total sales revenue” for profits. Also, twodecision criteria or objectives have been advanced viz., asatisfactory level of profit and the highest sales possible. Inother words, the firm is no longer viewed as working towardsone objective alone. Instead, it is portrayed as aiming atbalancing two competing and non-consistent goals. Baumol’s BABASAB PATIL (BEC DOMS )
  34. 34. MANAGERIAL ECONOMICSmodel is based on the view that managers’ salaries, theirstatus and other rewards often appear as closely related tothe companies’ size in which they work and is measured bysales revenue rather than their profitability. As such,managers may be more concerned to increased size thanprofits. And the firm’s objective thus becomes salesmaximisation rather than profits maximisation.Empirical studies of pricing behaviour also give results thatdiffer from those of the economic theory of firm as can beseen from the following examples: o Several studies of the pricing practices of business firms have indicated that managers tend to set prices by applying some sort of a standard mark-up on costs. They do not attempt to estimate marginal costs, marginal revenues or demand elasticities, even if these could be accurately measured. o For many firms, prices are more often set to attain, a particular target return on investment, say, 10 per cent, than to maximise short or long-run profits. o There is some evidence that firms experiencing declining market shares in their industry strive more vigorously to increase their sales than do competing firms, which are experiencing steady or increasing market shares.An alternative model to profit maximisation is the concept ofwealth maximisation, which assumes that firms seek tomaximise the present value of expected net revenues over allperiods within the forecasted future.As pointed out by Haynes and Henry, a study of thebehaviour of actual firms shows that their decisions are notcompletely determined by the market. These firms have somefreedom to develop decisions, strategies or rules, whichbecome part of the decision-making system within the firm. BABASAB PATIL (BEC DOMS )
  35. 35. MANAGERIAL ECONOMICS This gap in economic theory has led to what has come to be known as ‘Behavioural Theory of the Firm’. This theory, however, does not replace the former but rather powerfully supplements it. The behavioural theory represents the firm as an adoptive institution. It learns from experience and has a memory. Organisational behaviour, is embodies into decision rules and standard operating procedures. These may be altered over long run as the firm reacts to “feedback” from experience. However, in the short run, decisions of the organisation are dominated by its rules of thumb and standard methods.CONCLUSIONThe various gaps between the economic theory of the firm and theactual decision-making process at the firm level are many in number.They do, however, stress that economic theory seriously needs majorfixing up and substantial changes are in progress for creating betterand different models. Thus the classical economic concepts like thoseof rational man is undergoing important changes; the notion ofsatisfying is pushing aside the aim of maximisation and newer linesand patterns of thoughts are being developed for finding improvedapplications to managerial decision-making. A strong emphasis is laidon quantitative model building, experimentation and empiricalinvestigation and newer techniques and concepts, such as linearprogramming, game theory, statistical decision-making, etc., arebeing applied to revolutionise the approaches to problem solving inbusiness and economics.MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIESA managerial economist can play a very important role by assisting themanagement in using the increasingly specialised skills andsophisticated techniques, required to solve the difficult problems ofsuccessful decision-making and forward planning. In business BABASAB PATIL (BEC DOMS )
  36. 36. MANAGERIAL ECONOMICSconcerns, the importance of the managerial economist is thereforerecognised a lot today. In advanced countries like the USA, largecompanies employ one or more economists. In our country too, bigindustrial houses have understood the need for managerial economists.Such business firms like the Tatas, DCM and Hindustan Lever employeconomists. A managerial economist can contribute todecision-making in business in specific terms. In this connection, twoimportant questions need be considered: 1. What role does he play in business, that is, what particular management problems lend themselves to solution through economic analysis? 2. How can the managerial economist best serve management, that is, what are the responsibilities of a successful managerial economist?Role of a Managerial EconomistOne of the principal objectives of any management in itsdecision-making process is to determine the key factors, which willinfluence the business over the period ahead. In general, these factorscan be divided into two categories: External Internal The external factors lie outside the control of managementbecause they are external to the firm and are said to constitutebusiness environment. The internal factors lie within the scope andoperations of a firm and hence within the control of management, andthey are known as business operations. To illustrate, a business firm isfree to take decisions about what to invest, where to invest, how muchlabour to employ and what to pay for it, how to price its products, andso on. But all these decisions are taken within the framework of aparticular business environment, and the firm’s degree of freedomdepends on such factors as the government’s economic policy, theactions of its competitors and the like. BABASAB PATIL (BEC DOMS )
  37. 37. MANAGERIAL ECONOMICSEnvironmental Studies of a Business FirmAn analysis and forecast of external factors constituting generalbusiness conditions, for example, prices, national income and output,volume of trade, etc., are of great significance since they affect everybusiness firm. Certain important relevant factors to be considered inthis connection are as follows: The outlook for the national economy, the most important local, regional or worldwide economic trends, the nature of phase of the business cycle that lies immediately ahead. Population shifts and the resultant ups and downs in regional purchasing power. The demand prospects in new as well as established markets. Impact of changes in social behaviour and fashions, i.e., whether they will tend to expand or limit the sales of a company’s products, or possibly make the products obsolete? The areas in which the market and customer opportunities are likely to expand or contract most rapidly. Whether overseas markets expand or contract and the affect of new foreign government legislations on the operation of the overseas plants? Whether the availability and cost of credit tend to increase or decrease buying, and whether money or credit conditions ahead are likely to easy or tight? The prices of raw materials and finished products. Whether the competition will increase or decrease. The main components of the five-year plan, the areas where outlays have been increased and the segments, which have suffered a cut in their outlays. The outlook to government’s economic policies and regulations and changes in defence expenditure, tax rates tariffs and import restrictions. BABASAB PATIL (BEC DOMS )
  38. 38. MANAGERIAL ECONOMICS Whether the Reserve Bank’s decisions will stimulate or depress industrial production and consumer spending and how will these decisions affect the company’s cost, credit, sales and profits. Reasonably accurate data regarding these factors can enable themanagement to chalk out the scope and direction of their ownbusiness plans effectively. It will also help them to determine thetiming of their specific actions. And it is these factors, which presentsome of the areas where a managerial economist can make effectivecontribution. The managerial economist has not only to study theeconomic trends at the micro-level but also must interpret theirrelevance to the particular industry or firm where he works. He has todigest the ever-growing economic literature and advise topmanagement by means of short, business-like practical notes. Inmixed economy like that of India, the managerial economistpragmatically interprets the intentions of controls and evaluates theirimpact. He acts as a bridge between the government and the industry,translating the government’s intentions and transmitting the reactionsof the industry. In fact, the government policies emerge out of theperformance of industry, the expectations of the people and politicalexpediency.Business OperationsA managerial economist can also be helpful to the management inmaking decisions relating to the internal operations of a firm inrespect of such problems as price, rate of operations, investment, expansion or contraction. Certain relevant questions in this context would be as follows: What will be a reasonable sales and profit budget for the next year? What will be the most appropriate production schedules and inventory policies for the next six months? What changes in wage and price policies should be made now? BABASAB PATIL (BEC DOMS )
  39. 39. MANAGERIAL ECONOMICS How much cash will be available next month and how should it be invested?Specific FunctionsThe managerial economists can play a further role, which can coverthe following specific functions as revealed by a survey pertaining toBrittain conducted by K.J.W. Alexander and Alexander G. Kemp: Sales forecasting. Industrial market research. Economic analysis of competing companies. Pricing problems of industry. Capital projects. Production programmes. Security / Investment analysis and forecasts. Advice on trade and public relations. Advice on primary commodities. Advice on foreign exchange. Economic analysis of agriculture. Analysis of underdeveloped economics. Environmental forecasting. The managerial economist has to gather economic data, analyse allrelevant information about the business environment and prepareposition papers on issues facing the firm and the industry. In the caseof industries prone to rapid theological advances, the manager mayhave to make continuous assessment of tl1e impact of changingtechnology. The manager may need to evaluate the capital budget inthe light of short and long-range financial, profit and marketpotentialities. Very often, he also needs to prepare speeches for thecorporate executives. It is thus clear that in practice, managerialeconomists perform many and various functions. However, of all these,the marketing functions, i.e., sales force listing an industrial market BABASAB PATIL (BEC DOMS )
  40. 40. MANAGERIAL ECONOMICSresearch, are the most important. For this purpose, the managers may collect statistical records ofthe sales performance of their own business and those rehiring totheir rivals, carry out analysis of these records and report on trends indemand, their market shares, and the relative efficiency of their retailoutlets. Thus, while carrying out heir functions, the managers mayhave to undertake detailed statistical analysis. There are, of course,differences in the relative importance of· the various functionsperformed from firm to firm and in the degree of sophistication of themethods used in performing these functions. But there is no doubtthat the job of a managerial economist requires alertness and theability to work uriderpressure.Economic IntelligenceBesides these functions involving sophisticated analysis, managerialeconomist may also provide general intelligence service. Thus theeconomist may supply the management with economic information ofgeneral interest such as competitorsprices and products, tax rates, tariff rates, etc.Participating in Public DebatesMany well-known business economists participate in public debates.The government and society alike are seeking their advice and views.Their practical experience in business and industry adds prestige totheir views. Their public recognition enhances their protégé in the .firm itself.Indian ContextIn the Indian context, a managerial economist is expected to performthe following functions: Macro-forecasting for demand and supply. Production planning at macro and micro levels. Capacity planning and product-mix determination. BABASAB PATIL (BEC DOMS )
  41. 41. MANAGERIAL ECONOMICS Economics of various production lines. Economic feasibility of new production lines / processes and projects. Assistance in preparation of overall development plans. Preparation of periodical economic reports bearing on various matters such as the companys product-lines, future growth opportunities, market pricing situation, general business,. and various national/international factors affecting industry and business. Preparing briefs; speeches, articles and papers for top management for various chambers, Committees, Seminars, Conferences, etc Keeping management informed of various national and International Developments on economic/industrial matters. With the adoption of the new economic policy, themacro-economic environment is changing fast and these changeshave tremendous implications for business. The managerialeconomists have to playa much more significant role. They ha1e toconstantly measure the possibilities of translating the rapidly changingeconomic scenario into workable business opportunities. As Indiamarches towards globalisation, the managerial economists will have tointerpret the global economic events and find out how the firm canavail itself of the various export opportunities or of establishing plantsabroad either wholly owned or in association with local partners.Responsibilities of a Managerial EconomistBesides considering the opportunities that lie before a managerialeconomist it is necessary to take into account the services that areexpected by the management. For this, it is necessary for amanagerial economist to thoroughly recognise the responsibilitiesand obligations. A managerial economist can serve the mana¬gementbest by recognising that the main objective of the business, is tomake a profit on its invested capital. Academic training and the BABASAB PATIL (BEC DOMS )
  42. 42. MANAGERIAL ECONOMICScritical comments from people outside the business may lead amanagerial economist to adopt an apologetic or defensive attitudetowards profits. There should be a strong personal conviction on partof the managerial economist that profits are essential and it isnecessary to help enhance the ability of the firm to make profits.Otherwise it is difficult to succeed in serving management. Most management decisions necessarily concern the future, whichis rather uncertain. It is, therefore, absolutely essential that amanagerial economist recognises his responsibility to makesuccessful forecast. By making the best possible forecasts andthrough constant efforts to improve, a managerial ng, the risksinvolved in uncertainties. This enables the management to· follow amore orderly course of business planning. At times, it is required forthe managerial economist to reassure the management that animportant trend will continue. In other cases, it is necessary to pointout the probabilities of a turning point in some activity of importanceto management. In any case, managerial economist must be willing tomake fairly positive statements about impending economicdevelopments. These can be based upon the best possibleinformation and analysis. The managements confidence in amanagerial economist increases more quickly and thoroughly witha record of successful forecasts, well documented in advance andmodestly evaluated when the actual results become available. A few consequences to the above proposition need also be emphasised here. First, a managerial economist has a major responsibility to alert mana¬gelI1ent at the earliest possible moment in case there is an err6r in his forecast. This will assist the mallagement in making appropriate adjustment in policies and programmes and strengthen his oWn position as a member of the management team by keeplrighis fingers on the economic pulse of the business. Secondly, a managerial economist must establish and maintain BABASAB PATIL (BEC DOMS )
  43. 43. MANAGERIAL ECONOMICS many contacts with individuals and data sources: which would not be imme¬diately available to the other members of the management. Extensive familiarity with reference sources and material is essential. It is still more important that the known individuals who are specialists in particular fields have a bearing on tpe managerial economists work. For this purpose, it is required that managerial economist joins professional associations and tak~ active part in them. In fact, one of the best means of determining the quality of a managerial economist is to evaluate his ability to obtain information quickly by personal contacts rather than by lengthy research from either readily available or obscure reference sources. Within any business, there may be a wealth of knowledge and experience but the managerial economist would be really useful ifit is possible pn his part to supplement the existing know-how with additional information and in the quickest possible manner. Again, if a managerial economist is to be really helpful to themanagement in successful decision-making and forward planning, itis necessary" to able to earn full status on the business team.Readiness to take up special assignments, be that in study teams,committees or special projects is another important requirement. Thisis because it is necessary for the managerial economist to wincontinuing support for himself and his professional ideas. Clarity ofexpression and attempting to minimise the use of technicalterminology while communJcating his ideas to management executivesis also an essential role so as to win approval. To conclude, a managerial economist has a very important role toplay by helping management in successful decision-making andforward planning. But to discharge his role successfully, it is necessaryto recognise the relevant responsibilities and obligations. To somebusiness executives, however, a managerial economist is still a luxuryor perhaps even a necessary evil. It is not surprising, therefore, to findthat while tneir status is improving and their impor;ance is gradually BABASAB PATIL (BEC DOMS )
  44. 44. MANAGERIAL ECONOMICSrising, managerial economists in certain firms still feel quite insecure.Nevertheless, there is a definite and growing realisation that they cancontribute significantly to the profitable growth of firms and effectivesolution oftMir problems, and this promises them a positive future.REVIEW QUESTIONS 1. What is managerial economics? How does it differ from traditional economics? 2. Discuss the nature and scopeofmanagerial economics. 3. Show the significance of economic analysis in business decisions. 4. Managerial Economics is perspective rather than descriptive in character? Examine this statement. 5. Assess the contribution and limitations of economic analysis to business decision-making. 6. Briefly explain the five principles, which are basic to the entire gamut of managerial economics. 7. Explain the role of marginal analysis in determining optimal solution if managerial economics. How does it compare with break-even analysis? 9.Discuss some of the important economic concepts and techniques that help busirless management. 10.Explain the various functions of a managerial economist. How can he best serve the management? BABASAB PATIL (BEC DOMS )
  45. 45. MANAGERIAL ECONOMICS LESSON – 2 DEMAND ANALYSISDemand is one of the crucial requirements for the existence of anybusiness firm. Firms are interested in their profit and sales, bothof which depend partially upon the demand for the product. Thedecisions, which management makes with respect to production,advertising, cost allocation, pricing, inventory holdings, etc. callfor an analysis of demand. While how much a firm can producedepends upon its capacity and demand for its products. If there isno demand for a product, its production is unworthy. If demandfalls short of production, one way to balance the two is to createnew demand through more and better advertisements. The morethe future demand for a product, the more inventories the firmwould hold. The larger the demand for a firms product, the higheris the price it can charge. Demand analysis seeks to identify and measure the forces thatdetermine sales. Once this is done the alternative ways ofmanipulating or managing demand can easily be inferred.Although, demand for a finris product reflects what theconsumers buy, this can be influenced through manipulating thefactors on which consumers base their demands. Demand analysisattempts to estiinate the demand for a product in future, whichfurther helps to plan production based on the estimated demand.MEANING OF DEMAND Demand for a good implies the desire of an individual to acquire the product. It also includes willingness and ability of ail individual to pay for the product. For example, a misers desire for and his ability to pay for a car is not demand, for he does not have the necessary will to pay for the car. Similarly, a poor persons desire for· and his willingness to pay for a car is not demand because he lacks the BABASAB PATIL (BEC DOMS )
  46. 46. MANAGERIAL ECONOMICSnecessary purchasing power. One can also imagine an individual,who possesses both the will and the purchasing power to pay for agood. But this purchasing power is not the demand for that good,this is because he does not have the desire to buy that product.Therefore, demand is successful when there are all the three factors:desire, willingness and ability. It should also be noted that demandfor any goods or services has no meaning unless it is stated withreference to time, price, competing product, consumers incomes,tastes and preferences. This is because demand varies withfluctuations in these factors. For example, the demand for anAmbassador car in India is 40,000 is meaningless unless it is statedthat this was the demand ·in 1976 when an Ambassador cars pricewas around thirty thousand rupees. The price of the competing cars’prices were around the same, a Bajaj scooters price was around fivethousand rupees and petrol price was around three and a half rupeesper litre. In 1977, the demand for Ambassador cars could bedifferent if any of the above factors happened to be different.Furthermore, it should be noted that a product is defined withreference to its particular quality. If its quality changes it can bedeemed as another product. Thus, the demand for any product is thedesire, wi1lihigness and ability to buy the product with reference toa partkular time and given values of variables on which it depends.TYPES OF DEMANDThe demand for various kinds of goods is generally classified on thebasis of kinds of consumers, suppliers of goods, nature of goods,duration of consumption goods, interdependence of demand,period of demand and nature of use of goods (intermediate or final),The major classifications of demand are as follows: Individual and market demand Demand for firms prodtictand industrys products Autonomous and derived demand Demand for durable and non-durable goods BABASAB PATIL (BEC DOMS )
  47. 47. MANAGERIAL ECONOMICS Short-term and long-term demand Individual and Market DemandThe quantity of a product, which an individual is willing to buy at aparticular price during a specific time period, given his moneyincome, his taste, and prices of other commodities (particularlysubstitutes and complements), is called individuals demand for aproduct. The total quantity, which all comsumers are willing to buyat a given price per time unit, given their money income, taste, andprices of other commodities is known as market demand for thegood. In other words, the market demand for a good is the sum ofthe individual demands of all the c6-nsumers of a product, over atime period at given prices.Demand for Firms Product and Industrys ProductsThe quantity of a firms yield, that can be disposed of at a given priceover a period refers to the demand for firms product. The aggregatedemand for the product of all firms of an industry is known as themarket-demand or demand for industrys product. This distinctionbetween the two kinds of demand is not of much use in a highlycompetitive market since it merely signifies the distinction between asum and its parts. However, where market structure is oligopolistic, adistinction between the demand for firms product and industrysproduct is useful from managerial point of view. The product of eachfirm is so differentiated from the products of the rival firms thatconsumers treat each product different from the other. This givesfirms an opportunity to plan the price of a product, advertise it inorder to capture a larger market share thereby to enhance profits. Forinstance, market of cars, radios, TV sets, refrigerators, scooters,toilet soaps and toothpaste, all belong to this category of markets. In case of monopoly and perfect competition, the distinctionbetween demand for a firms product and industrys product is not ofmuch use from managerial point of view. In case of monopoly, BABASAB PATIL (BEC DOMS )
  48. 48. MANAGERIAL ECONOMICSindustry is one-firmindustiy andthe demand for firms product is thesame as that of the industry. In case of perfect competition, productsof all firms .of the industry are homogeneous and price for each firmis determined by industry. Firms have little opportunity to plan theprices permissible under local conditions and advertisement by afirm becomes effective for the whole industry. Therefore, conceptualdistinction between demand for films product and industrysproduct is not much use in business decisions making.Autonomous and Derived DemandAn Autonomous demand for a product is one that arisesindependently of the demand for any other good whereas a deriveddemand is one, which is derived from demand of some other good. Tolook more closely at the distinction between the two kinds of demand,consider the demand for commodities, which arise directly from thebiological or physical needs of the human beings, such as demand forfood, clothes and shelter. The demand for these goods is autonomousdemand. Autotnomous demand also arises as a result ofdemonstration effect, rise in income, and increase in population andadvertisement of new produCts. On the other hand, the demand for agood that arises because of the demand for some other good is calledderived demand. For instance, demand for land, fertiliser andagricultural tools and implements are derived demand, since thedemand of goods, depends on the demand of food. Similarly, demandfor steel, bricks, cement etc., is a derived demand because it isderived from the demand for houses and other kind of buildings. [ngeneral, the demand for, producer goods or industrial inputs is aderived one. Besides, demand for complementary goods (whichcomplement the use of other goods) or for supplementary goods(which supplement or provide additional utility from the use of othergoods) is a derived demand. For instance petrol is a complementarygoods for automobiles and a chair is a complement to a table.Consider some examples of supplement goods. Butter is supplement BABASAB PATIL (BEC DOMS )
  49. 49. MANAGERIAL ECONOMICSto bread, mattress is supplement to cot and sugar is supplement totea. Therefore, demand for petrol, chair, and sugar would beconsidered as derived demand. The conceptual distinction betweenautonomous demand and derived demand would be useful accordingto the point of view of a bllsinessman to the extent the former canserve as an indicator of the latter.Demand for Durable and Non-durable GoodsDemand is often classified under demand for durable and non-durablegoods. Durable goods are those goods whose total utility is notexhausted in single or short-run use. Such goods can be usedcontinuously over a period of time. Durable goods may be consumergoods as well as producer goods. Durable consumer goods includeclothes, shoes, house furniture, refrigerators, scooters, and cars. Thedurable producer goods include mainly the items under fixed assets,such as building, plant and machinery, office furniture and fixture. Thedurable goods, both consumer and producer goods, may be furtherclassified as semi-durable goods such as, clothes and furniture anddurable goods such as residential and factory buildings and cars. Onthe other harid, non-durable goods are those goods, which can beused only once such as food items and their total utility is exhaustedin a single use. This category of goods can also be grouped undernon-durable consumer and producer goods. All food items such asdrinks, soap, cooking fuel, gas, kerosene, coal and cosmetics fall inthe former category whereas, goods such as raw materials, fuel andpower, finishing materials and packing items come in the lattercategory. The demand for non-durable goods depends largely on theircurrent prices, consumers income and fashion whereas the expectedprice, income and change in technology influence the demand for thedurable good. The demand for durable goods changes over a relativelylonger period. There is another point of distinction between demandsfor durable and non-durable goods. Durable goods create demand for BABASAB PATIL (BEC DOMS )
  50. 50. MANAGERIAL ECONOMICSreplacement or substitution of the goods whereas non-durable goodsdo not. Also the demand for non-durable goods increases ordecreases with a fixed or constant rate whereas the demand fordurable goods increases or decreases exponentially, i.e., it maydepend· upon some factors such as obsolescence of machinery, etg.For example, let us suppose that the annual demand for cigarettes in acity is 10 million packets and it increases at the rate of half-a-millionpackets per annum on account of increase in population when otherfactors remain constant. Thus, the total demand for cigarettes in thenext year will be 10.5 million packets and 11 million packets in thenext to next year and so on. This is a linear increase in the demand fora non-durable good like cigarette. Now consider the demand for adurable good, e.g., automobiles. Let us suppose: (i1 the existingnumber of automobiles in a city, in a year is 10,000, (ii) the annualreplacement demand equals 10 per cent of the total demand, and (iii)the annual autonomous increase ·in demand is 1000 automobiles. Assuch, the total annual clemand for automobiles in four subsequentyears is calculated and presented in Table 2.1. Table 2.1: Annual Demand for AutomobilesBeginning Total no. of Replacement Annual Total Annualof the year automobiles demand autonomous demand increase (Stock) demand in , ; demand st 1 year 10,000 - - 10,000 - 2nd year 10,000 1000 1000 12,000 _ 2000 -3id year 12,000 1200 1000 14,200 2200 4th year 14,200 1420 1000 16,620 2420 Stock + Replacement + Autonomous demand = TotalDemand It may be seen from the Table 2.1 that the total demand forautomobiles is increasing at an increasing rate due to accelerationin the replacement demand. Another factor, which might acceleratethe demand for automobiles and such durable goods, is the rate ofobsolescence of this category of goods.Short-term and Long-term Demand BABASAB PATIL (BEC DOMS )
  51. 51. MANAGERIAL ECONOMICSShort-term demand refers to the demand for goods that aredemanoed over a short period. In this category fall mostly the fashionconsumer goods, goods of seasonal use and inferior substitutesduring the scarcity period of superior goods. For instance, the demandfor fashion wears is short-term demand though the demand for thegeneric goods such as trousers, shoes and ties continues to remain along¬term demand. Similarly, demand for umbrella, raincoats,gumboots, cold drinks and ice creams is of seasonal nature; Thedemand for such goods lasts till the season lasts. Some goods of thiscategory are demanded for a very short period, i.e., 1-2 week, forexample, new greeting cards, candles and crackers on occasion ofdiwali. Although some goods are used only seasonally but are durable inpature, e.g., electric fans, woollen garments, etc. The demand for suchgoods is of also durable in nature but it is subject to seasonalfluctuations. Sometimes, demand for certain gools suddenly increasesbecause of scarcity of their superior substitutes. For examp1e, whensupply of cooking gas suddenly decreases, demand for kerosene,cooking coal and charcoal increases. In such cases, additional demandis of shGrt¬term nature. The long-term demand, on the hand, refersto the demand, which exists over a long-period. The change inlong-term demand is visible only after a long period. Most genericgoods have long-term demand. For example, demand for consumerand producer goods, durable and non-durable goods, is long-termdemand, though their different varieties or brands may have onlyshort-term demand. Short-term demand depends, by and large, onthe price of commodities, price of their substitutes, current disposableincome of the consumer, their ability to adjust their consumptionpattern and their susceptibility to advertisement of a new product. Thelong-term demand depends on the long-term income trends,availability of better substitutes, sales promotion, and consumer creditfacility. The short-term and lcmg-term concepts of demand are usefulin designing new products for established producers, choice of BABASAB PATIL (BEC DOMS )
  52. 52. MANAGERIAL ECONOMICSproducts for the new entrepreneurs, in pricing policy and indetermining advertisement expenditure.DETERMIN!NTS OF MARKET DEMANDThe knowledge of the determinants of market demand for a productand the nature of relationship between the demand and itsdeterminants proves very helpful in analysing and estimating demandfor the product. It may be noted at the very outset that a host offactors determines the demand for a product. In general, followingfactors determine market demand for a good: Price of the good- . Price of the related goods-substitutes, complements and supplements Level of consumers income Consumers taste and preference Advertisement of the product Consumers expectations about future price and supply position Demonstration effect and bend-wagon effect’ Consumer-credit facility Population of the country Distribution pattern of national income. These factors also include factors such as off-season discountsand gifts on purchase of a good, level of taxation and general socialand political environment of the country. However, all these factorsare not equally important. Besides, some of them are not quantifiable.For example, consumers preferences, utility, demonstration effectand expectations, are difficult to measure. However, both quantifiableand non-quantifiable determinants of demand for a product will bediscussed.1. Price of the ProductThe price of a product is one of the most important determinants of BABASAB PATIL (BEC DOMS )